Trading Systems and Methods, 6th Edition

CHAPTER 13Spreads and Arbitrage

For both spreads and arbitrage, traders seek to take advantage of price differences or divergence. 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. An arbitrage between two similar companies or similar products that diverge, when there is a history of similar price movement, such as two microchip manufactures, or U.S bonds and the Euro-bund, 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 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 ...