What is spread trading and how is it done operationally?

Spread trading is an investment strategy that involves the simultaneous purchase and sale of two related assets, with the aim of profiting from the price difference between them. Widely used in financial markets, this technique, also known as market spread, allows you to exploit the relative price variations between similar instruments. Spread trading allows you to have a neutral position on the market, protecting the trader from any changes in the trend.

But what is the spread in trading? It is the difference between the purchase price (bid) and the sale price (ask) of an asset. A practical example of currency spread trading consists of simultaneously trading two currency pairs, trying to profit from the fluctuations of their price differential. To understand how to do spread trading, it is essential to monitor market conditions, analyze the graphs and understand the relationship between the various financial instruments.

What is spread trading: meaning and definition

spread trading (or pair trading) is an operating technique that consists of opening two opposite positions, one long and one short, on two correlated assets and allows traders to earn with a more neutral position than the normal long and short.

In the stock market, therefore, it will be a matter of buying and selling two securities belonging to the same sector, but the same concept can be applied to futures, options, raw materials, stock indices, physical currencies and cryptocurrencies.

Spread trading allows those who use it to take a neutral position with respect to the market, thus managing to earn without the trend of the financial markets being able to affect the profit of the position. Unlike directional trading, where you bet on the rise or fall of an asset, spread trading focuses on the relative movement between two related instruments.

How does spread trading work

What is spread trading? The name already suggests an idea of how to do spread trading. The translation of “spread” is “differential,” so those who use spread trading earn on the difference in yield generated by a financial instrument.

The most common spread trading technique is to secure a profit by going long (i.e. buying) on a company’s stock and short (i.e. selling short) on another stock. The most common approach is to buy and sell two stocks in the same sector, buying the stronger stock and selling the weaker one.

Similarly, forex spread consists of buying a currency pair and selling another. More complex is financial spread trading on two related bond futures but with different durations, for example the TBond 30 year and the TNote 10 year.

From an operational point of view, spread trading can be done with different approaches: let’s look at them together.

The divergent approach

We talk about divergent Pair trading when a stock has a greater relative strength than another in the same sector. In this case, we could aim for the continuation of the main trend, going long on the stronger and short on the weaker.

The convergent approach

We talk about a convergent approach when, of two stocks belonging to the same sector, one is overvalued, while the other is undervalued. Using mere technical analysis, it is possible to search for the "optimal situation" in which the undervalued stock is close to a support, while the undervalued one is close to a divergence. In this context, we will aim for a realignment in which the prices of the two companies return to their “fair value”. In other words, this approach exploits the “mean reverting” properties of the spread between the two instruments.

The correlation coefficient approach

How do we establish the spread pairs? To get an idea of how two assets interact with each other, we use the concept of correlation. The correlation helps identify the instruments that move in tandem and those that move in opposite directions. It is expressed with numerical values between -1 and 1: the closer the coefficient is to -1, the more the two securities will tend to move in opposite directions, vice versa when this factor is close to 1. Once this filter has been applied, it will be easier to select the best securities.

Subsequently, it will be possible to verify the behavior that the two assets have had in the past, trying to understand whether the spread trading approach is truly applicable or not. If the answer is yes, we will proceed with a study (of cointegration) to identify the typical price behaviors of the two instruments over time. Cointegration is a statistical property of time series used to verify whether the linear combination of variables is stationary. Each deviation from the average value of the spread represents a statistical anomaly and offers a spread trading opportunity.

Spread trading: a practical example

Let’s now look at an example to better understand the meaning of spread trading. Let’s consider the stocks of the Italian banking sector Unicredit and Intesa Sanpaolo. The two stocks are moving in the same direction, but with different strengths: since the beginning of the year we have noticed that Unicredit is performing better than Intesa Sanpaolo.

To do spread trading, we can follow two paths:

• for those who prefer technical analysis, it will be enough to note a stock in the sector that is performing better than the average and a stock that is underperforming;
• for those who are familiar with fundamental analysis, you can choose stocks that have more or less strong balance sheets.

At this point, having chosen the two stocks, Unicredit and Intesa Sanpaolo, we will position ourselves long on the one we believe to be stronger and short on the one we believe to be weaker, trying to earn on the performance differential.

Suppose we invested €1,000 in each stock on February 6, 2025:

• We bought 30 Unicredit shares at €33 for a value of €990
• We sold 293 Intesa Sanpaolo shares at €3.38

We decide to close the spread on May 6, when Unicredit reached a price of €43.80 and Intesa Sanpaolo €4.13:

• By trading long on Unicredit we earned €321
• By trading short on Intesa Sanpaolo we lost €219.75

Spread trading between the two stocks led to an overall gain of €101.25.

Spread trading does not have a predefined time frame, it can be used over periods that are also very different in time. This is why those who have little time to follow the performance of the stock markets prefer spread trading, since it is not necessary to follow the performance of the portfolio in real time.

Spread trading: other types to know

There are also other types of spread trading, even if the one presented previously is the most common. The other methods are:

• intramarket spread trading;
• intermarket spread trading.

Intramarket spread trading

The intramarket spread, as the term itself suggests, is that trading technique that is based on the differential gain of the same market. For example, many traders study the historical trends of the same instrument which does not necessarily have to be a stock but can also concern a commodity or an index or even a currency pair.

By studying historical data, it is possible to see the trend over time of an instrument, which can perform better in some months but worse in others. For example, think of a Gold futures.

We notice that gold performs better in May and worse in December and therefore we will decide to go long on gold in May and short in December, thus trying to earn on the differential of the two trends.

This can also be done in a combined way: in addition to gold, we know that WTI oil performs better in April and worse in September. Therefore, while waiting to operate on gold, we can operate on oil in the same way explained above.

Intermarket trading spread

The intermarket spread is based on the differential gain generated by two different markets. Let’s suppose that the banking sector performs better between September and November while the automotive sector performs worse. It would be possible to go long on the first and short on the second (for example using ETFs) profiting from the differential of the two returns.

The same thing can be applied to commodities, indices and currencies, the underlying in spread trading is not important but the performance of a specific instrument is.

The advantages of spread trading

Spread trading presents us with a series of advantages that must be considered. Below you will find the main advantages of this operating method, so as to understand if it is the right way to operate:

• each spread is a protected position, in fact having a future in purchase and a future in sale. In this way you are protected from any price fluctuations;
• since there is a lower risk, it is possible to operate with a much lower margin than usual;
• the return on invested capital, however, can be higher than usual;
• there are tools and very specific techniques for choosing a trend, in this way it becomes easier to choose correctly;
• one of the major benefits is that of seasonality, as spreads are seasonal and, therefore, choosing them in the right season increases the probability of earning;
• it is possible to enter trends with high profits, in fact when spreads move they do so for a longer period of time than a single future;
• for all these reasons, working with spreads is much less stressful than single operations.

Obviously, spread trading is not a system to earn money always and in any case, but a way of operating with which you must become familiar with daily exercise.

In this regard, it is correct to test this system on a free demo.

Although spread trading is an investment method that allows you to remain neutral, you can still lose a lot of money. Consequently, it is better to be cautious and have a clear trading strategy.

The disadvantages of spread trading

After having seen the advantages that this trading strategy brings us, we must also evaluate its disadvantages. In fact, spread trading has limitations that lead some traders not to choose it as an investment method.
The main disadvantages of spread trading are:

• profit limited to one unit of contract: the variations on the spread and the sudden changes in the price of the contracts are limited. Consequently, operating in this way also risks having limited profit margins. To try to resolve this inconvenience, you must therefore try to open a significant number of positions, so as to be able to earn on multiple fronts;
• higher commission costs: traders, to operate in this mode, must open double the positions and consequently the commission costs increase.

Before concluding our in-depth analysis of spread trading, let’s look at the last, but not least, element: the money to invest.

How much to invest in spread trading?

The amount of money to go short and long with is generally the same since it is assumed that the profit is amplified in one direction or the other.

You will therefore have to open two positions that are equal in amount of money, but opposite in type of position. In this way you will have a neutral position.

Returning to the example of Unicredit and Intesa Sanpaolo (long on one and short on the other), we start from the assumption that if the banking sector does well, Unicredit will perform better than the sector while Intesa Sanpaolo will do so to a lesser extent. This is how the profit is created, managing to earn thanks to spread trading.

Conversely, if the banking sector does badly, Unicredit (on which we are long) will fall but to a lesser extent than Intesa Sanpaolo (on which we are short).
This is why, generally, you use the same amounts of money - you can even decide to put more money on one than the other but the strategy would then lose its neutrality.

Original article published on Money.it Italy. Original title: Cos’è lo spread trading e come si fa operativamente