Trading Systems and Methods, + Website, 5th Edition

CHAPTER 13

Spreads and Arbitrage

For both spreads and arbitrage, traders seek to take advantage of price differences, relative differences, or anticipated differences. 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, such as AMR and UAL, 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. (When academics use the term arbitrage, it implies risk-free, although nothing is risk-free.) When the reason for two markets to diverge is not a fundamental disparity, such as a location arbitrage (the difference in price caused by transportation between two locations), but rather market forces acting differently on two similar products, the trade is a relative value 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 the yield curve will steepen (yields on short-term maturities will drop faster than long-term ...