Fixed income spread trading is a special and more complexed form of trading.
The difference between scalping or direction trading and spread trading is that in spread trading you trade two instruments at the same time with opposite direction. In that way you have a more hedged position than if you trade outright. It is more hedged but not perfectly hedged as if it would be then you wouldn’t be able to earn profit on the spread positions.
When you trade spreads you trade the price difference between two instruments.
It could be a calendar spread when the underlying instrument is the same, but you trade different expirations. Classical example is the commodities. For example you buy January Crude Oil and at the same time you sell February Crude Oil.
I trade spreads between different instruments.
In my case the traded instruments are the German government bonds.
Looking that 3 instruments you can get a 3 point yield curve (2yr, 5yr, 10yr points with the concerning yields ).
When you trade the spreads of these 3 instruments, it means that you trade a part of the yield curve.
It means the difference between the 2 yr yield and the 5 yr yield.
To be able to calculate with it we use the following formula to get the value of the spread:
2.5*Schatz price – Bobl Price
for example if the last traded prices were Schatz 108.135 and Bobl 116.360 then
153.978 that is the spread value.
If you want to trade this spread you should trade it with a ratio of 8:3
If you want to buy the spread you buy 8 lots of Schatz and sell 3 lots of Bobl.
Bobl – Bund Spread
It means the difference between the 5 yr yield and the 10 yr yield.
Its formula is the following:
1.6*Bobl price – Bund price
if the last traded prices were Bobl 116.360 and Bund 122.22, then the spread value is
So the Bobl-bund spread value is 63.96
If you want to trade this spread the trade ratio is 3:2
If you want to buy the spread, you buy 3 lots of Bobl and Sell 2 lots of Bund.
The butterfly is the difference of the two above mentioned spreads.
In case of a butterfly the position have three legs. You have the Schatz leg the Bobl leg and the Bund leg. The body of the butterfly is the Bobl and the two wings are the Schatz and the Bund.
If you have a butterfly position then the body have to be in the opposite direction to the wings.
If you buy a butterfly then you buy Schatz sell Bobl and buy Bund.
The formula for the butterfly is the following:
Bund price – 3*Bobl price + 4*Schatz price
for example if we take the prices from the examples above Schatz price 108.135 Bobl price 116.360 and Bund price 122.22
then the value of the butterfly will be:
122.22 – 3*116.360 + 4* 108.135 = 205.68
In case of a butterfly you trade the same ratio as it is in the formula
spread, butterfly, formula, ratio, schatz, bobl, bund