If you are at least a little familiar with exchange trading, you've surely already come across the term spread. It is a frequently used term which, however, occurs in various contexts and therefore represents several different phenomena. As a result, there is often confusion regarding the spread interpretation and it is also often used in wrong contexts. Therefore, let's have a look at this term a little closer.
The essence of the term spread is the same in all trading contexts - it always represents a price range. In other words, it is a difference between two price values.
The most common use of spread in trading relates to the difference between the bid and ask prices.
Let's demonstrate this on two examples. In the picture you can see a screenshot from the Interactive Brokers trading platform. On the first row there is a contract of corn with expiration in December 2013. As you can see, the current BID price is $426.75 and the current ASK price is $427. The spread between the two values is thus $427 - $426.75 = $0.25.
As a second example there is a contract of heating oil. In this case, the BID price is $2.9299 and the ASK price is $2.9305. The price range, i.e. spread, is therefore $0.0006.
These were the two examples of the most common use of the term spread. However, this term can also be used in many other contexts.
Another most frequent use of the term spread relates to option trading. The most basic meaning of the spread in options trading is the difference, i.e. the price range, between the spot price (market price, i.e. the price for which the underlying asset can be instantly bought or sold) and the strike price of the underlying asset.
In the picture you can see a screenshot from the ThinkorSwim (TOS) trading platform. The LAST price of the Russell 2000 index was $1,111.87 and the displayed strike prices range between $1,065 and $1,160. In this case, the spread would equal to the difference between the spot price of the index (i.e. market price at which it is possible to immediately open the trading position) and the selected strike price. Let’s assume that the spot price is $1,111.87 and the strike price is $1,130. The spread value will therefore equal to $18.13. However, this is not a typical use of the term spread in option terminology.
The most often use of the spread term in option trading relates to combination of long and short positions of options of the same type (i.e. put or call) on the same underlying asset, but with different strike prices and different expirations. The spread in this case represents the price range between the two strike prices. There are three types of these spreads in option trading:
Another area in which we can work with spreads is a futures contracts trading. In this context we can often come across the term commodity spread, although this term is somewhat misleading. It is because it does not only relate to trading commodities, but to almost all types of underlying assets traded as futures. The proper term should therefore be futures spreads.
Also in case of commodity spreads this term represents a price range. Futures spreads are, like in option trading, based on the principle of a combination of long and short positions. In this case, we distinguish the following 4 types of spreads:
The charts above display the chart of sugar with expiration in October 2012 and next to it the chart of sugar with expiration in May 2013. Below the two charts there is so called spread chart which shows increase/decrease of the price range between long and short positions in sugar futures contracts with expirations in October 2012 and May 2013.
The spread in this case is $23.51 – $23.20 = $0.31.
At first glance, commodity spread trading may seem complicated, but the opposite is true. This trading method is suitable even for absolute beginner traders. Its advantage is that it provides a very good return on trading capital - tens of percent a year. If you are interested in this trading approach, read our article Why to trade commodity spreads and futures spreads? If you would like to learn this trading approach, subscribe to our Course of Commodity Spread Trading.
This article summarised the ways of use of the term spread in exchange trading. We explained that the very basic interpretation of this term is always the same – the spread always represents a range between two price values. We described a concrete use of spread trading in three most typical contexts. We hope that this brief overview provided you a basic understanding of spread trading and that it facilitate your next steps in further education and successful trading.
Next chapter: Why to trade commodity spreads and futures spreads?
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