Relative Value and Spread Trading

Relative Value and Spread Trading in Futures

Good morning! Coffee in hand, screens aglow – let’s talk trading. A question I often get from colleagues is: What exactly are “relative value” and “spread” trades, and why do we use them in futures markets? If you’re a curious junior professional or savvy retail investor, stick around. I’ll break down these concepts in plain English, with real-market perspective. By the end, you’ll understand how we trade equity index futures and short-end fixed income futures (think SOFR, 2-year, 5-year, 10-year Treasury futures) using relative value strategies, the tug-of-war between mean reversion and momentum, and why risk management is the name of the game (especially when leverage is involved). Let’s dive in!

What Are Relative Value and Spread Trades (and Why Should We Care)?

Relative value (RV) trading is essentially comparative shopping in the markets. Instead of betting on a single asset going up or down, we’re looking at the price relationship between two related assets. If one looks cheap and the other looks pricey relative to each other’s history or fundamentals, a relative value trader buys the undervalued one and sells the overvalued one – in other words, we go long the “cheap” asset and short the “rich” asset at the same time. This paired trade structure (long/short) is called a spread trade because we’re trading the spread (difference) between two prices rather than the outright price level of one asset.

Why do this? Two big reasons. First, it helps neutralize market direction risk. Since you have both a long and a short, you’re less exposed to the entire market’s ups or downs and more focused on the gap between the two assets. In futures markets, a spread trade is literally the simultaneous purchase of one futures contract and sale of another. Instead of saying “I think the market will go up” or “down,” you’re saying “I think Asset A will do better relative to Asset B.” For example, rather than betting the S&P 500 Index alone will rise or fall, you might bet that the Nasdaq 100 will outperform or underperform the S&P 500 by trading one against the other. We care about RV trades in futures because they let us express nuanced views (tech vs. broad market, or one part of the yield curve vs. another) and often with lower volatility than a one-legged trade. In fact, because the two legs are usually correlated, spreads are generally less volatile (and considered less risky) than outright positions, and exchanges even reward this with lower margin requirements for many spread positions.

Secondly, relative value strategies can improve risk-adjusted returns and diversification for a portfolio. Since a well-crafted spread trade is often market-neutral (not much correlated with overall market swings), adding these trades can give you smoother performance and unique sources of profit. In hedge fund land, we love terms like “uncorrelated alpha” – that’s basically what a good RV trade offers: a chance to profit from mispricing without simply riding the market up or down.

Alright, enough theory – let’s get concrete with two arenas where RV spreads are popular: equity index futures and fixed income futures.

Relative Value in Equity Index Futures: Nasdaq vs. S&P Spread