The global capital market does not only consist of directional trades. In the global marketplace, a majority of institutions have internal rules for compliance and risk management. Even though these institutions are ready to commit huge capital, their risk appetite is not too big. That’s when it becomes important to understand what is spread in trading.
Published on 03 March 2023
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As the name indicates, spread trading is useful for trading the difference between two prices. Therefore, it primarily revolves around tracking the fluctuations of this difference instead of the asset price directly. Let us understand more about what is spread in trading, its different types, and its benefits.
What is Spread Trading?
A spread trade can be referred to as a pair of trades taken by an investor. One of them includes buying a particular option or future. The other one involves selling off another option or future at the same time. The two parts of a spread are usually known as "legs”. The legs lead to the fluctuations in price that the investor needs to receive profits.
While understanding what is spread in trading, you should know that this strategy is also called "relative value trading”. In this type of trading, the primary goal of traders is to capitalize on and protect profits from a narrowing or widening spread in the stock market.
Types of Spreading Trading Strategies
Now that you know what is spread in trading let’s concentrate on its different types. The variations of spread trading depend on the security traders are interested in. The two primary variations in spread trading are as follows:
● The Option Spread
Traders pick two different options as legs for this type of spread in the stock market. Even though the options vary, they need to be associated with similar securities in the spread trade. Therefore, there will be some kind of link between the two chosen options.
● The Inter-Commodity Spread
Under this trading strategy, the trader will deal with two commodities that appear to have no similarities with each other. But if you know what is spread in trading, you will realize that there will be some link between the two securities. A similar concept is also applicable to companies expanding upwards or downwards. But in this case, it comes from the side of the traders.
How Does Spread in Trading Function?
The spread in the stock market is one critical piece of information to be familiar with while figuring out trading expenses. The spread of any instrument is denoted by a variable number, and it has a direct influence over the trade value. The market price or current price of the asset is necessary to construct spreads.
To simplify the transaction process, brokers and market makers include additional transactional costs in the spread. This practice is particularly prevalent in the case of future and forward contracts. In the stock market, the spread is influenced by the following factors:
Liquidity: It can be figured out by the volume of trades. Transferring a liquid asset into cash is much easier than transferring a non-liquid asset. Assets that are traded easily are usually known to possess a wider spread. On the other hand, commonly traded assets possess a tighter spread.
Volatility: Volatility refers to massive price movement in the market rapidly. The spread is pretty wide in a volatile market. Several market-makers leverage volatility to widen their spread, and traders can profit from fluctuations in market prices.
Price: The price of an asset is associated with volatility as well as liquidity. When the asset price is low, volatility is higher, while liquidity is lower. It results in a wider spread and, in the opposite scenario, is low in case of high asset prices.
Benefits of Spread Trading
Now that you know what is spread in trading and how it works, let's discuss some of its benefits.
A major advantage of this trading strategy is that there’s no need to look after the spread all day long. Similar to long-term delivery positions, you will be able to trade spreads without having to concentrate on real-time data.
Spread trading is ideal for program traders and all institutional traders. They will be able to identify spreads before the market with the help of a computing edge.
Another huge advantage of spread trading is that the margin requirements are extremely low. Therefore, spreads are able to occupy a huge market position despite offering lower profits. It is true for commodities as well as index or equity spreads.
Wrapping up
The trading strategy is useful for first-time traders as well as experienced traders with a low-risk appetite because it can bring value even in volatile markets. Therefore, become familiar with a spread in the stock market and start leveraging the strategy for your profits.
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If you find yourself wanting to learn about the stock market but dread the written word and verbose stock market jargon, stock market movies can come to your rescue. Stock market movies are a great way to gain insight into the world of finance yet enjoy some added drama, mystery, and theatrics.
Diwali, the festival of lights, is one of the most prominent Indian festivals. It marks the beginning of the Hindu accounting year called Samvat. Most people consider Diwali an auspicious occasion to make financial investments because of the blessings of Goddess Laxmi.
Top 15 Frequently Asked Questions(FAQs) on Stock Market
Investing in the stock market can be curiosity-inducing but nerve-racking, especially for beginners. Even expert traders often have questions about the stock market and the factors that influence it. So, as a lay investor, it is only natural to be confused about the ways of the stock market and its vast terminology.
If you find yourself wanting to learn about the stock market but dread the written word and verbose stock market jargon, stock market movies can come to your rescue. Stock market movies are a great way to gain insight into the world of finance yet enjoy some added drama, mystery, and theatrics.
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