What Is Spread Trading?
Spread trading is a form of speculative trading that leverages the buy/sell spread of a security and your investment amount to determine what the gains or losses of the position will be when it’s closed. It’s commonly associated with forex indexes and is an advanced trading strategy that requires a Level 2 trader account, for real-time access to the spreads of securities from market makers.
With real-time information on bid/ask amounts, traders can use their due diligence to speculate on the movement of a security and open a position relative to that movement. The bid amount is multiplied by change in the spread – its net loss or net gain.
Profit (and Loss) Are in the Spread
The defining factor to pay attention to while spread trading is the size of the spread. The tighter the spread – usually you’re looking for one point or less – the lower your risk. Generally, less volatile securities come with a tighter spread. For more volatile securities, such as cryptocurrency, the spread is larger to accommodate for the instability in the price. In this way, spread trading index funds is less risky than spread trading crypto, for example. But as with most investments, risk and reward are in direct proportion.
An Overview of Spread Trading
Spread trading works by leveraging your long or short position and bid amount against the spread of an index. Let’s look at a practical example.
On Monday, the Shanghai SE Composite Index spread is 3,550-3,551, with the former representing the sell price and the latter representing the buy price. You believe the index will rise and take out a long position for $10 at 3,551. By Friday, the Shanghai SE Composite Index has risen to 3,800, representing a 249-point gain. The spread is now 3,800-3,801. You close your long position on the spread, which multiplies your $10 bid by the 249-point increase, netting you $2,490.
Things could also go the other way, resulting in a loss. If the index falls to 3,301 and the spread becomes 3,301-3,302, your long position is worth -$2,500. Closing that position assumes the liability of that loss.
The Fundamentals of Spread Trading
The speculation and gamble that come with spread trading make it both a lucrative strategy and a dangerous one. The more correct you are, the more money you’ll make. The less correct you are, the more you’ll lose.
The chief advantage spread traders have is time. You can open a position for as long as you have confidence in it – months, weeks, days, hours or even minutes. Time in a position depends on many factors, but primarily how far above or below the initial bid the price is currently.
There are several different types of spread trading actions, including bull and bear calls, as well as bull and bear puts, depending on whether you want to take a short or long position in a security. Moreover, many traders use options spreads to control their risk by setting minimum and maximum strikes to cap gains and losses. This trends into advanced options trading strategies beyond simple spread trades.
The Bottom Line on Spread Trading
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Spread trading is a lucrative strategy for traders capable of doing due diligence and predicting market movement through technical analysis. Failing to understand how to hedge against losses and maximize gains can leave traders vulnerable to unexpected market fluctuations. All in all, spread trading is a strategy best reserved for experienced, confident and technically sound traders.