What is a spread?

In finance, a spread trade (also known as relative value trade) is the simultaneous purchase of one security and sale of a related security, called legs, as a unit. Spread trades are usually executed with options or futures contracts as the legs, but other securities are sometimes used (see Wikipedia).

What is the benefit of trading spreads?

A single position

Let us first analyze what happens if we only trade a single position which is not a spread position. Let's assume that we have analyzed that there will be a seasonal effect in Heating Oil in a way that the price increases in early winter when all the people start to buy heating oil. Let's assume as an action from the analysis we buy heating oil in August with the target to sell it in February the following year. As we own Heating oil our position in Heating oil will change with the change of other Oil prices. As heating oil is a raw crude oil crack and produced out of crude oil it will react to movements in the crude oil market. Let's assume that due to some geo political events the price of crude oil goes down by 30%. Probably our Heating oil position will be influenced by the price movement from crude oil (due to the fact that Heating oil is cracked from crude oil). Even if there is a seasonal effect (and our theoretical assumption from the beginning of increasing heating oil prices in winter is correct) the overall influence and price movement of the general oil market will bring us a loss with a single position. Scenario single position: Our example calculation here is

August February P&L
Heating Oil bought 100 sold 70 loss 30

A spread position

Let us now analyze the same trade but as a spread with two positions, Heating Oil and Crude Oil. Let's again assume we analyzed that heating Oil is most expensive in August and cheapest in February. In addition of buying Heating Oil we sell Crude Oil at the same moment we buy Heating Oil (Note: Futures can be bought and sold even without owning the position - read for short trading). Let us look for different scenarios:

Scenario 1 spread (the same as in the "single position scenarios" but as spread)

We buy Heating Oil for 100 and Crude Oil for 100 in August and due to a general drop in Oil all Oil cracks fall by 30%.

August February P&L
Heating Oil bought 100 sold 70 loss 30
Crude Oil sold 100 brought 70 win 30

The loss and the win substitute each other and the result is 0

Scenario 2 spread (the same as in SCENARIO1 but under the assumption that Heating Oil increases more than the other Oils)

We buy Heating Oil for 100 and Crude Oil for 100 in August and due to a general drop in Oil most Oil cracks fall by 30% but Heating Oil falls less due to high demand for heating Oil in Winter against other Oil.

August February P&L
Heating Oil bought 100 sold 75 loss 25
Crude Oil sold 100 brought 70 win 30

The win in Heating Oil could make good for the loss in Crude Oil and the total profit is 5. The profit of 5 is due to the change in the ratio (spread) between Heating oil (which has a higher request in winter) and Crude Oil.

The scenario 2 shows that the spread trading is based on the idea that the ratio between two comparable contracts change over time. The total market movement (here the 30% loss) has no influence on the position or their profit. As long as both positions are effected by the same force in the same strength there is no influence on profit. Only the change in relative value between the two positions effect the profit of the spread position.

Scenario 3 spread

For a spread we would typically combine two things from which we assume that they differ (spread) away from each other in the directional dimension of the spread. For example Gasoline (known as Petrol or Benzin) is mostly used in summer when people drive car and there is a lot of traffic while it is less used in winter time when snow falls. Heating Oil behaves in contrast to Gasoline as Heating Oil has the highest consumption when it is cold.

In the graph above you can see a typical seasonal oscillation of Gasoline and Heating Oil over the seasons of the year. Such an oscillation is typical for some seasonal commodities and in spread trading traders try to buy at a maximum spread of A vs. B and sell at a maximum of B vs. A to get a maximum profit. Note that the movement of the total market (Oil market) has probably no influence on the profit of the spread as the ratio will stay the same if both commodities are influenced by the same absolute number (the market movement).

January September P&L
Heating Oil bought 20 sold 100 win 80
Crude Oil sold 80 brought 50 win 30

In this example both positions have made a win in total of 110 as the ration of the positions has moved in our favor.

Let us now assume that the market has moved 10 points down in September and all Oil contracts were down by 10.

January September P&L
Heating Oil bought 20 sold 90 (=100-10) win 70
Crude Oil sold 80 bought 40 (=50-10) win 40

We subtract 10 from both September contracts as the market has moved down but the profit of the spread is still 110. A market movement has no influence on the spread as long as it is equal on the both spread legs. No matter if the market goes up or down the profit is made in the ratio between the two contracts which is predicted by our scientific research.

Spreads are typically used to exclude external effects (external dimensions) and to focus on just one dimension (the ratio between contracts). Typical dimensions on which a spread is focused is time (for example one Heating Oil contract has a delivery date in Winter, the other in summer; time spreads are called Intracommodity or Calendar spreads as synonym); crack spreads (like Heating Oil and Crude Oil), process, spark or crush spreads (like milk and butter or feeder cattle and cattle) and many more spreads.


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