Term spread

Term spread trade (also known as relative value trade) represents a market position when an investor holds a long position in one contract and short position in another contract with the same or similar underlying asset. The spread then represents the difference between the long position and the short position. Spread trades are most commonly executed with futures or options contracts, but other securities such as bonds can be used as well.

Spread trade creates a unique market neutral position. If the underlying asset of a spread trade gains on value over the time of spread trade, the investor earns a profit on the long position, while loosing on the short side. So with spread trade, an investor does not attempt to earn a profit on trending price moves of an underlying asset. His attempt is to profit from widening or narrowing of the spread. Buying a spread then means betting on spread to widen, with longing the contract with a higher price and shorting the one with lower price. Selling a spread means doing the opposite.

Many forms of spread trading can be observed. One of the most common forms of spread trading is intra-market calendar spreads. Intra-market calendar spreads are executed by buying and selling contracts with different delivery date and are mostly used with commodities as an underlying asset. These contracts price the expectation of supply and demand in different future time points.

Another well-known form is bond yield spread trading. Yield spread represents the difference between yields on two bonds with different maturities. The indicating factor for yield spread trading is the yield curve. This curve reflects the yield for bonds with different maturities. Usually, the investor, who invests in bonds with longer maturity bears more risk and is rewarded with a higher return. Therefore the yield curve has a growing shape. Depending on economic conditions and situation, this curve can steepen or flatten, and that is when spread traders can earn a profit. When the economy is expecting a recession, the curves have a tendency to flatten, in time of expansion they steepen.

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    The Encyclopedia of Quantitative Trading Strategies

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