CHAPTER 30

The Concepts and Mechanics of Spread Trading

There was a one-lot trader named Fred, who tried to reduce risk with a spread. But the spread was his demise— He overdid position size, trading not 1 but 10 instead.

Introduction

Despite widespread publicity and extensive information, spreads still remain an often misunderstood and relatively little-used trading vehicle. There is nothing inordinately complicated about spread trading; many traders simply lack the familiarity with the concepts involved. Ironically, it is usually the novice trader, for whom spreads can be a particularly useful trading vehicle, who shuns them as an esoteric operation confined to the “pros.” Furthermore, even experienced traders often exhibit a bias against trading spreads, preferring to trade in outright positions because of their greater potential. These traders fail to realize that, at times, spreads may offer a more attractive reward/risk ratio than outright positions. In other words, at a given time, X number of spreads may offer equal potential to a one-contract outright position but imply a smaller risk. (Of course, such a judgment will always be subjective.)

Spreads—Definition and Basic Concepts

A spread trade involves the simultaneous purchase of one futures contract against the sale of another futures contract either in the same market or in a related market. Normally, the spread trader will initiate a position when he considers the price difference between two futures contracts ...

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