Spread Trading Strategies: Different Strokes for Different Folks

A spread trade can take on many forms. It may be helpful to think of a spread like a bridge that is combining two assets together. Usually, these assets complement each other, and when used together, they often offset risk, but it could be at the price of some gains. However, for some investors, they could be a useful strategy to consider within their portfolio.

Professional investors and traders use spread trades through a variety of avenues: futures spreads, options spreads, so-called pairs trading, and more. Individual investors can apply spread trading strategies as well, according to Harrison Napper, director of digital product management at TD Ameritrade. But it’s critical to first understand how spread trading works, as well as your investing or trading mentality. Pairs trading requires active monitoring and management and is not appropriate for everyone.

The following are a few key questions and basics on spread trading.

What Is a Spread Trade?

Broadly speaking, a spread is a market position that has two or more “legs,” including a “long” position that, in theory, gains value if the price of the underlying asset rises, and a “short” position that gains if the price declines. The “spread” is the price difference between the long position and the short position.

Part of the goal “is to find some kind of relationship between two things,” Napper said. “Effectively, you’re trading the relationship, not the two assets.”

What’s the Point of a Spread Trade?

Often, the rationale behind a trading strategy involves a trade-off (e.g., limiting risk in exchange for limiting upside potential). Many spread traders aim to reduce short-term volatility in an underlying position by “spreading” off the risk. In many cases, spread trading allows traders to theoretically define their risk. 

Some investors strive to track the S&P 500 or other broad market benchmark over the long haul. Spread traders, by contrast, may be thinking more aggressively and trying to outperform the broader market. Or they may aim to capitalize on a short-term hunch without affecting their longer-term strategy or goals. 

“If you’re comfortable doing about the same as the rest of the market, you may not want to use spreads,” Napper said. “If you want to attempt to do better than the rest of the market, and you’re comfortable with the additional risks involved, then options-based spreads can help you attempt to do that. Spreads offer a tool to more finely tune your trade ideas.”

Calendar, or “Time Spreads”, Are Common Options Spread Strategies

A calendar spread is considered a defined-risk strategy that involves selling a short-term option and buying a longer-term option of the same type (calls or puts).

Calendars are designed to profit from the passing of time, not an underlying’s movement. Over time, the goal is for the shorter-term option to “decay” faster than the longer-term option, so the position profits when the spread can be sold for more than you paid for it (risk is typically limited to the debit incurred).

Calendars and other options-based spreads can be applied to prepare for near-term events, such as quarterly earnings.

Vertical Spreads, Collars, and Other Spread Trading Strategies

A vertical spread is typically an options position composed of either all calls or all puts, with long options and short options at two different strikes. The options are all on the same underlying and of the same expiration, with the quantities of long options and short options balancing to zero.

Feeling bullish? That’s when a long call vertical or short put vertical may serve you. Alternatively, long put verticals and short call verticals are considered bearish positions. In addition to transaction costs, the risk of a long vertical is typically limited to the debit of the trade, while the risk of the short vertical is typically limited to the difference between the short and long strikes minus the credit. Also, keep in mind that carrying options positions into expiration can entail additional risks; for example, an unanticipated exercise/assignment event could occur or an anticipated event may fail to occur.

A collar spread—which involves a short call and a long put along with a long stock position—is another common options-based spread trade. Part of the idea is to have the premium collected from a short call offset the premium paid for a put, limiting your upside potential but protecting against a price drop in the underlying stock. (Learn more about other forms of spread trading, including the iron condor.)

How Does a Pairs Trading Strategy in Stocks Work?

A common spreading tactic in equities, pairs trading often involves taking a bullish position in one stock or exchange-traded fund (e.g., buying 100 shares or buying call options, for example), while also taking a bearish position in another (e.g., shorting another company’s stock or buying put options).

Pairs trading often involves stocks that are positively correlated and/or in the same industry, meaning the shares usually move in the same direction over long periods. Pairs trading can also be applied to bonds, currencies, and other assets.

Pairs traders keep their eyes open for opportunities when two historically correlated underlyings diverge (e.g., one stock moves up while the other moves down). A trader might then take a market position that, in theory, will make money when the two stocks eventually converge again. For examples of pairs trading, see “Pairs Trading: Your Yummy New Snack.”

Final Points on Spread Trading

Spread trading can be a valuable component of an investing strategy for some investors, but Napper cautioned it can also get very complicated, very quickly. Throw in leverage (borrowed money), and spread trading can go beyond relatively straightforward hedging into the realm of speculation. In fact, many traders use spread trading exclusively for speculation.

It’s important for investors considering spread trades to grasp the difference between hedging and speculation. According to Napper, spread trading “can be a highly leveraged way to make money very quickly—or lose money very quickly.” Hedging and speculating are among the tools of a long-term strategy. As investors, some will want to be able to use both these tools, but they must understand the risks first.