Spread trading represents buying one financial instrument and selling the same one or other related financial instrument as a unit. The net position of these transactions is the difference between the sell price of the bought instrument and the buy price of the sold instrument, also called the spread. Spread trading is mostly realized with commodity futures or options contract which can be used in many variations. These variations include for example spread on the same financial instruments (futures or options) which are expiring in different months, spread on related financial instruments with the same maturity or spread on related financial instruments bought/sold on different exchanges.
This strategy possesses many benefits as it is safer than trading single financial instruments, it requires only some percentage of the total value of the trade and it’s cost-efficient with lower exchange fees and no need for live data. As mentioned earlier, spread trading could be used on any asset class, but it’s mainly used in commodity market from which are also our examples of well-known WTI/Brent Spread.
WTI and Brent are two acknowledged and most-watched kinds of crude oil. American WTI is only a little different from European Brent in its efficiency in creating gasoline, production and transportation. Spread on these commodities is made by going long WTI futures contract and short side Brent futures contract with the same maturity. As both oils are very similar, their spread shows signs of strong predictability and usually oscillates around some average value. It is, therefore, possible to use deviations from the fair spread value to bet on convergence back to fair value.
Another example of a spread trading strategy can be, for example, based on the spread between Natural gas and Propane, which is called “Frac spread” and is created by a 3:1 or 5:2 propane-to-natural gas futures positions. The economic theory says that the relative mispricing between Natural gas and Propane could exist for relatively short horizons. But extended mispricing will likely force producers and processors to cut production of natural gas, and hence the supply of Propane until output revenue and input price reach a long-run equilibrium relationship.