Spread trading often confuses new traders. Basically what is done in spread trading is to combine a long and short position at the same time in related futures contract. Two prices are quoted for all the spread bets. One is the buy price at which a person goes long when the market of expected to rise and the other is the sell price at which the person goes short when the market is expected to fall. The difference between the buy price and the sell price is known as the spread. The profit comes from the spread between the two prices.
The idea behind spread trading is to reduce the risk of holding only a short or long position. This can be made clearer with an example. Suppose you trade on a spread in gold, now if the prices of gold increases then the gain on the long position will offset the loss in short one. If the prices of gold would fall, the reverse would be true.
There are basically three different kinds of spreads:
These types of spreads have your long and short futures in different months but in the same market. For example you are Long July Soybeans and at the same time Short December Soybeans.
This can be accomplished if you go short futures with one market and long futures with another market at the same month. For example Short May Soybean and Long May Corn.
Inter exchange spreads
These are accomplished by contracts in similar market but on different exchanges. They can be in different months or same months. For example Long May Chicago Rice and Short July Kansas Rice. An example of the same month would be Long July Chicago Rice and Short July Chicago Rice.
Spreads can be very profitable and valuable but it is important to start with basics and then move to the higher stuff. The spreads are less risky as the commodity futures offer lower margin rates. For beginners the spread trading is better, as it is less volatile. The prices move less quickly in spreads which is not the case with other trades. Other trades have lot of price fluctuations and speed like in a single outright trade in the futures market. You are provided with unique hedging opportunities in variety of commodities if you opt for spread. This also helps reduce the initial cost by allowing the trader to pay less in margin by funding the purchased future or with the sale of the other side of the spread.
These can be very effective for trading and are a purer form of trading. In spreads you can avoid the problems that related to lack of liquidity. You can easily trade in less liquid markets and that is why you have more trading options with spreads. These offer greater odds of winning rather than greater possibilities of losing. These are an excellent way to trade tendencies that are seasonal as the percentage of wins increases in comparison to the losses. In an inverted market you can make profits by two possibilities. Once when the prices invert and once when they return to normal progression.
Spreads are neither difficult to understand nor is dangerous to trade. If one is looking for a trading style that has very low margin requirements, is very easy to trade and produces an even higher return on the margin then you should go for spreads.