Trading spreads is a sophisticated method that involves creating strategic positions to profit from the differences in asset prices. Understanding market dynamics and utilizing various types of spreads, such as vertical and collar spreads, is crucial to manage risk and capitalize on market movements.
Introduction to Spread Trading
Spread trading is a popular trading strategy that involves taking positions in two or more correlated assets to profit from the relationship between them. This approach can be used to capitalize on price differences, yield curves, or interest rate spreads. Spread trading is a multi-faceted strategy that can adapt to a range of market conditions, making it a versatile tool for traders. By understanding the mechanics of spread trading, traders can develop a keen awareness of the broader market forces at play and make informed decisions. Whether you’re dealing with futures contracts, options spreads, or other financial instruments, mastering spread trading can provide a significant edge in the financial markets.
How to spread trade?
All orders to buy and sell cryptocurrencies are summarized in one table, called a “order book”. It reflects orders that are pending execution, broken down separately into bid and ask prices. According to the law of supply and demand, the buyer always wants to buy cheaper, and the seller wants to sell at a higher price. Therefore, there is always a better bid price (the buyer’s price) and a better offer price (the seller’s price).
The spread is the difference in prices when buying and selling a particular asset, known as the bid ask spreads, which is the difference between the buyer's price and the seller's price.
Let us consider this with the help of a concrete example.
Suppose that you want to buy Bitcoin. During negotiations you may say that you are ready to pay $10000 for one coin. This is the “ask” price. However, the seller is certain that the Bitcoin is worth more and refuses to sell it for less, for example, for $12,000. This is the seller’s “bid” price. The difference between the bid price ($10000) and the ask price ($12000) is $2000 - that is the spread.
The value of the spread depends on the following factors.
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Liquidity. The higher the liquidity, the lower the spread value. Some cryptocurrencies trade regularly and in high volumes, while others do not. The low liquidity increases the price range.
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The situation on the market. Political and economic events constantly affect the cryptocurrency exchanges. These can be company reports on their activities, including financial ones, important reports on the state of affairs in industry or world markets, political and economic collapses, and various force majeure events. Often before important news arrives, traders reduce trading volumes so as not to take risks. Reduced liquidity leads to spread widening.
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Volume of orders. For example, the order to buy a huge amount of cryptocurrency cannot be sold at one price. Part of the order will be sold at one price and part at another. All these actions lead to an increase in the spread.
The spread can be fixed or variable.
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The fixed spread is the gap between the buy and sell prices, which does not change in any way, regardless of how the market price changes. The fixed spread is often used when you want to simplify your trading.
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The variable spread is the gap between the buy and sell prices, which changes depending on the current market price. The variable spread is used in cryptocurrency markets where market conditions change rapidly.
The spread is named narrow when the difference between the ask and bid prices is minimal. If the distance between them becomes larger, the spread widens. Correspondingly, the widespread is observed when the difference between the bid and ask prices is significant. There is no limit to this widening. It is regulated only by market makers when they consider it necessary.
Additionally, transaction costs play a crucial role in the profitability of spread trading. These costs should be carefully considered as they can significantly impact the net gain or loss from a trade.
What is a slippage?
Cryptocurrencies are a highly volatile market. The spread here is often associated with slippage.
Market uncertainty plays a significant role in causing slippage in cryptocurrency trading.
Slippage is a situation where a trader’s market order is not executed at the market price, but at a nearby price but more liquid value.
Here is an example. A trader has decided to sell 10 ETH for $1300 in one order. If the stock market does not provide this order at the price, the order can be fully or partially executed at close values. Suppose the exchange sold 3 ETH at $1300, 4 ETH at $1295, and 3 ETH at $1305 for the trader. The trader expected to get $13,000, but because of slippage, he received $12,995 (not including commissions).
Slippage does not always result in a loss. Sometimes the trader gets more than he expected. For example, if in our example 4 ETH are sold at $1301 instead of $1295, the total would be $13,019. This is a positive slippage.
Spread Types
In practice of trading on the financial markets, there are several types of spreads. Thus, apart from the bid-ask spread, professional traders and investors operate with others as well. Spread trading works by simultaneously buying and selling related financial instruments to profit from price discrepancies.
Spread trading approaches include divergent and convergent strategies, each with its own methods and risks, especially when using leverage.
Intermarket spread
It happens that the same cryptocurrency is traded on the different exchanges at the different prices. This situation is called the intermarket spread and involves related financial instruments. It can arise for a variety of reasons - due to liquidity on a particular exchange, the presence of the market maker, and exchange transaction fees.
The spread between exchanges allows traders to earn on arbitrage. That is to buy an asset where it is cheaper and sell it on another exchange where it is more expensive. In arbitrage, it is necessary to take into account the commissions and the speed of transaction. So, the price on the second exchange does not fall by the time of sale, and the commission does not take away all the income.
Intercommodity spread
This is the difference between the prices of correlated or related assets on the same exchange. For example, there can be a relatively stable price difference between cryptocurrencies that are similar in characteristics or run on the same blockchain. It could also be the difference between two altcoins or two stablecoins.
A common example of intercommodity spreads is the crack spread, which is the price difference between crude oil and its refined products. Refiners monitor this spread as it indicates their profit margins and reflects the broader dynamics within the petroleum industry.
Intramarket spread (Calendar spread)
This is one type of intramarket spread that indicates the price difference between contracts for the same underlying asset but with different expiration dates.
The calendar spread is a futures or option strategy that includes simultaneously initiating long and short positions on the same underlying asset with separate delivery dates. Buying a longer-term contract and selling a short-term option with the same strike price is the classic calendar spread option. Both options must have the same expiration date to ensure the strategy's effectiveness.
Market Volatility
Market volatility can have a significant impact on spread trading. When volatility increases, the price difference between two correlated assets can widen, creating opportunities for traders to profit. However, high volatility can also increase the risk of losses if the spread widens in the wrong direction. To manage market volatility, traders can use various strategies, such as hedging or adjusting their position sizes. By understanding the effects of market volatility on spread trading, traders can develop effective risk management strategies and maximize their profits. It’s crucial to stay informed about market conditions and be prepared to adapt your trading strategy as needed to navigate the challenges of a volatile market.
Is it possible to decrease the spread?
The spread cannot be influenced directly, but it is possible to organize the trading process in order to reduce costs. Choosing strategies with a lower initial cost, such as a strangle spread, can help reduce overall trading expenses.
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Use the most liquid assets with the highest trade turnover. For them the difference between the ask and bid prices is minimal;
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Do not trade when the most important news is published, when the spread widening is most likely.
Futures spread trading strategies
A futures contract is a contract that guarantees the purchase of an asset at a certain time, in a certain volume and at a price agreed upon in advance. Such contracts can be traded and they guarantee execution of the transaction.
Futures contracts allow traders, investors and commodity producers to speculate on the future price of an asset. In other words, futures spread trading its deal in coins at the price, which is determined at the time the contract is made.
The exchange is responsible for compliance with the terms of the contract. When the date specified in the agreement comes, two events occur.
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The futures contract is removed from trading.
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The exchange automatically fulfills the agreements specified in the agreement. This process is called expiration.
A bull spread is a common strategy in futures trading, particularly useful in moderately bullish market conditions.
One of the main advantages of trading cryptocurrency futures is the ability to protect yourself from adverse price changes and the sharp volatility of the cryptocurrency, whatever it may be - Bitcoin or Ethereum. The high volatility of digital assets gives traders the opportunity to buy them at low prices and then sell them at higher prices, and vice versa.
Let’s see what is a spread strategy for minimizing cash losses when trading crypto futures.
This strategy involves trading at least two different contracts in tandem. Below are three different types of spreads. Note that they all use the types of spreads we discussed above.
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Calendar spread - contracts are concluded for two different periods. It works as follows. The trader makes the short contract with a few days or weeks expiry period and another long contract for a few months ahead.
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Intercommodity spread. The trader enters into two opposite positions for different assets with the same contract in order to trade on the relationship between the two commodities. At the same time, they must be interconnected (i.e. if one coin is increasing in value, the other should not decrease or also increase in value and vice versa).
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Intermarket spread. The trader makes deals on two different exchanges for the same asset and wins on the difference in price. For example, Binance and Kraken.
Traders can handle options related to the same stock to establish positions with different strike prices and expiration dates.
Strategies with the spread as a financial instrument are more suitable for traders. They work in the short and medium term. In the long term, it is more problematic to make money on the price gap between two assets. And there is no point: investment strategies are based on somewhat different principles.
The underlying asset's price plays a critical role in determining the profitability of futures spread trading strategies.
Using multiple leg options strategies can provide significant advantages in navigating the complexities of futures spread trading.
Risk Management
Risk management is a critical aspect of spread trading. Traders must carefully assess the potential risks and rewards of each trade and develop strategies to mitigate potential losses. This can include setting stop-loss orders, limiting position sizes, and diversifying their portfolios. By managing risk effectively, traders can protect their capital and increase their chances of success in the markets. Spread trading strategies, such as calendar spreads and inter-commodity spreads, can also be used to manage risk and profit from price differences. Implementing a robust risk management plan is essential for long-term success in spread trading, as it helps to limit risk and preserve capital during market fluctuations.
Trading Platforms
Trading platforms play a crucial role in spread trading. A good trading platform should provide traders with real-time market data, advanced charting tools, and efficient trade execution. Some popular trading platforms for spread trading include MetaTrader, TradingView, and Interactive Brokers. By choosing a reliable and user-friendly trading platform, traders can streamline their trading process and focus on developing effective spread trading strategies. The right platform can enhance your ability to analyze market trends, execute trades quickly, and manage your portfolio efficiently, ultimately contributing to your success as a spread trader.
Psychological Challenges
Spread trading can be psychologically challenging, especially for novice traders. The uncertainty of market movements and the potential for losses can create anxiety and stress. To overcome these challenges, traders must develop a trading mentality that is grounded in logic and discipline. This can include setting clear goals, developing a trading plan, and sticking to it. By managing their emotions and staying focused, traders can develop the mental toughness needed to succeed in spread trading. Additionally, traders can use various techniques, such as meditation and journaling, to manage their stress and stay motivated. Building a strong psychological foundation is just as important as mastering technical skills in the world of spread trading.
Spread betting on cryptocurrency
Spread betting is very popular with many traders.
The principle of spread betting is in the possibility of placing own bet for each point of price change, and it excludes real asset acquisition. Essentially, spread betting is basically a bookmaker’s nature, as it involves betting like on sports or other competitions. The difference is that the subject of the bet is the rate of financial instruments.
Financial spreading operates with the use of leverage and can potentially be a profitable method of investing, although it is associated with a certain degree of risk. Traders can forecast potential profit through various techniques, making it an attractive option for those looking to maximize gains. Therefore, it is more suitable for investors who:
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Have some experience in financial markets.
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Want to diversify their investment portfolio.
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Are more interested in short-term trading opportunities.
As in many other markets, you can bet on spread betting both up and down. Among the instruments available for trading, you can find almost any type of financial market asset - including cryptocurrencies.
Conclusions on crypto pairs trading
In our article, we looked in detail at what is spread trading in crypto, what it depends on, and how it can be applied in digital trading. Of course, it can be used for any crypto, that is, if you are trading the very first and most well-known coin, you will need knowledge of what is Bitcoin spread trading.
Achieving spread trading profitable outcomes involves complexities and challenges. Only a small percentage of traders succeed consistently, highlighting the importance of a well-structured trading plan, risk management, and experience in navigating the market dynamics.
Spread is one of the key concepts in trading. It can vary depending on many factors, such as supply and demand, trading volume and liquidity levels. Depending on the trader’s skills, the spread can lead to losses or profits. This is especially important for scalpers and intraday traders - market participants who create many trades with small target profits. Being inattentive to spread sizes will not allow you to make a stable profit.
