Q: Hi Guy, question regarding trading the flattening effect of the yield curve. From what it seems the play is to take a position in the short end opposing that of the long end. Can you explain why you’d use a spread? I would have thought that although both ends have different rates of change in the event of a rate change, they’d both move in the same direction?
A: Awesome question. Firstly you are right, products across the curve (almost always) move in the same direction. In this instance, instead of buying one and selling the other, a FAR MORE profitable trade would be to be in the same direction with both. The problem is, it carries far more risk also.
Most spread positions have a directional bias. So in a way getting a spread right is about getting overall market direction right. However, they can be far more forgiving when you are wrong. That means you can hold a position for longer, overnight for example.
They can also be a little more predictable. A lot of the spread traders will range trade more often with spreads than you could in outrights. If you identify a spread that trades mostly within a range, then selling high and buying low over and over is a whole lot easier than picking direction.
Here is a bit more to read on spreads: