How Spread Trading Can Cut Your Risks in Volatile Markets

The wild swings we’ve been experiencing in the markets lately are unprecedented. Even seasoned fund managers are left scratching their heads and assessing their risk/reward trading strategies.

It’s important to understand that volatility is a double-edge sword. The risk can be extreme. But if handled right, it can provide incredible opportunity to make sizable profits too.

The trick is being able to limit your risk and exposure while at the same time maximizing profit potential. That can often be a very difficult task. But it doesn’t have to be. One tool is available to you that makes that objective much more attainable: Spread trading.

Spread trading can be daunting to many investors who may be unfamiliar with it, so they avoid it. The language or concept can seem foreign and overly complex. However, it’s actually quite simple if you don’t let all the jargon make you nervous.

Basically, what you’re doing is taking a simultaneous long and short position in an attempt to profit. The profit comes from the differential, or “spread,” between two prices. A spread can be established between:

• Different months for the same commodity …
• The same or related commodities for the same month …
• The same or related commodities traded on two different exchanges …
• Stocks, options, ETFs and more.

One of the biggest reasons traders use this strategy is to cut down costs to enter a specific trade. By buying and selling you can offset the cost of buying by what you collect for selling the other side of the trade.

In addition, by owning both a long and short position you can hedge yourself and limit the risk to some extent. Of course it also limits your profit potential too. Even so, many traders prefer to limit risk even if it means profit potential is more limited too.

Spread Trading Pros vs. Cons

Spreads can be very valuable and profitable. But it’s important to start with the basics and then move on to the more exotic stuff when and if appropriate. Here are some basic pros and cons of spread trading:

Spreads can help reduce some of the risks of investing in a volatile market.

Pros

Spread trading can often offer lower margin rates because these strategies usually carry less risk. Thus, it can cut your initial costs.

Spreads are usually less volatile and prices move less quickly. This can be good if you’re a beginner who may be intimidated by the speed and price fluctuations of a single outright trade in the markets.

Spreads offer unique hedging opportunities in a variety of trading vehicles.

Cons

Spread trading has much higher transaction costs, usually double, simply because you’re using more than one trading vehicle. That’s why it’s even more important for you to have an excellent entry and exit point, because every penny will count.

Spreads are often not traded “outright.” In other words on their own in some markets, so you must “leg” into them, which can be tricky for the novice.

Spreads can be less liquid than other trades, which can be a problem if you’re trying to get out of a position in a hurry.

Spread trades have limited profit potential since you have bought and sold at the same time. Thus the profit potential is limited to the differential between the two. Of course the risk is more limited too.

My final word on spread trading: It can be an extremely effective tool in volatile markets like we are experiencing now. Even so, just like with all trading tools, before entering into any spread trade figure out if you really have a reason to be using this type of trade, what purpose does it serve?

If the answer is clear to you, then go right ahead! Remember the most important thing to watch with spreads are those pesky transaction costs — they can really add up … fast.

Regards,

Kevin Kerr

P.S. I’m about to release a spread trade for my Master Trader members. To learn how you can join them, RISK FREE, click here.