CHAPTER 13

Spreads and Arbitrage

Positions taken in opposing directions in related markets, contracts, options, or shares are generally referred to as a spread or straddle. When a long and short sale are entered simultaneously in two related stocks, the strategy is called pairs trading. When the dynamics of the spread can be definitively calculated, such as the price of two bonds of the same maturity and the same grade, or the price of gold in two different locations, the transaction can be considered an arbitrage. For futures markets, the most common use of the term spread relates to two delivery months of the same market. This can also be called an intramarket spread, an interdelivery spread, or a calendar spread. For example, a trader may take a long position in March Treasury bonds and sell short the June contract (for the same year). The expectation is that prices will rise (yields fall) and that near-term delivery will rise faster than the deferred, netting a larger profit on the long position and a smaller loss on the short sale. An intermarket spread can be taken in two stocks of the same industry group, such as American Airlines and UAL. General economic news will affect the airline stocks in the same way, but better management of one company will cause that stock to gain over the other. In the stock market this is also called pairs trading.

An intercommodity spread is the simultaneous purchase of one commodity and the sale of another related commodity. This is most ...

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