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Friday January 19, 2018
Education Print
Spread trading is when you buy a futures contract and sell a related futures contract at the same time.

When you do this you are trading the difference or spread price between the two contracts. The most popular type of spread trading is called calendar or intra-market spread, which means identical contracts are purchased (one long/the other short) with different expiration times; for example, long July and short December corn.

The second type is inter-market spreads which are closely related markets but with identical expiration times; for example long August lean hogs and short August live cattle. In some cases, inter-exchange spreads can be created by purchasing related contracts at different exchanges; for example long July wheat at the Chicago Board of Trade (CBOT) and short July wheat at the Kansas City Board of Trade (KCBOT).

In all cases, the spread trader assumes the risk between two different contracts.

A spread trader can just as easily trade the difference between Gold and Silver. Let’s say gold is US$1,000/oz and silver is US$20/oz. As a spread trader you might have the view that when gold and silver reach a (price) ratio of 50:1 the spread price is too narrow (historically) and that it should widen out to say 55:1. There is no view or expectation of whether gold and silver will move up or down in price – the spread trader is neither bullish nor bearish either metal necessarily. To benefit financially a trader can buy US$100,000 of gold and sell US$100,000 of silver (using 100 ounce futures contracts). Equal amounts of money are applied (for parity) and as the individual markets oscillate up and down or even trend in the same direction you can profit from one outpacing the other. After a while you note that the ratio (gold to silver price) has moved out to 55:1; both markets have moved lower in price, for example gold is now US$950/oz and silver is US$17.27/oz. The 100 ounces of gold bought at $1,000/oz is sold at $950 /oz (worth $95,000) amounting to $5,000 loss; the 5,000 ounces of silver sold at $20/oz can be purchased back at $17.27 amounting to a $13,650 profit. The net difference is $13,650 - $5,000 = $8,650 profit.The silver price outpaced the gold price. You can read the entire published article in FN Arena called An Introduction to Spread Trading section: www.fnarena.com.

In all spread trading the trader is looking for one leg of the spread to outpace the other in price.


Background and Benefits

Every trader is looking for an edge or strategy that can produce consistent profits without huge draw- downs. Futures spreads offers the leverage of futures contracts, helps hedge systemic risk (outside factors that can effect price), eliminates stops and we receive reduced risk without having to pay up for time premium as options traders do. A disadvantage of spread trading is that both positions or legs of the spread can move against you. Trading calendar spreads can be a far superior strategy over flat priced futures trading, options and option spreads when you factor in opportunity available, risk management, cost effectiveness and margin efficiency. In the stock markets spread trading (also known as pairs trading) is dominated by banks and hedge funds. It is similar in the futures markets where the major participants are producers and commodity funds. Any market can be spread traded and banks, primary producers and fund traders use spreads as their main trading strategy. Markets like grains, livestock, energies, softs and financials are more common than the indices, currencies and metals. The Commodity Research Bureau provides a list of commodities and their fundamental description: www.crbtrader.com. Below is a list of key benefits for using futures spreads.

Reduced volatility – spreads are a natural hedge and have less risk than an outright position. Spread trading is also referred to as “hedge trading” due to the nature of being long and short, especially in the same commodity i.e. calendar spread where you are more likely to have smoother trends and less stress in managing a position. The lower risk and volatility associated with most spreads is evident by the lower margin requirements.

Reduced margins – means that you can afford to hold multiple spread positions. The margin on an outright futures position in Heating Oil is $5,063; a calendar spread in Heating Oil requires $550 or 90% less in margin. That's an advantage for any trader but especially for small accounts with $10,000 or less. Lower margins means greater use of your capital and allows you to maintain multiple spread positions. The emotional and psychological impact of cutting a non-performing or losing trade is reduced while improving your confidence and management on profitable trades. The CME website provides margin requirements for CME, CBOT and NYMEX outright positions and their calendar spreads www.cmegroup.com. The wider range or diversification of trade selection is an important aspect to a balanced trading portfolio.

Position trader – as a trend trader in spreads you inherently become a position trader, that is you hold a trade more than one day. History shows us that many of the most successful traders are position traders. You need only one or two trades in the life of each spread, which means fewer trades, easier trade management and your chart data is free or very low cost for delayed data. This is a huge savings in your operating cost.

True market activity – majority of spreads are not held to the influence of running stops (market manipulation) and are less concerned with liquidity and slippage. Just Spreads uses only exchange-listed calendar spreads which means your position can be managed as effectively as an outright position using stops or most other order types. And because you’re holding identical contracts there is a more balanced effect on each leg of the trade opposed to an inter-market spread which has different fundamental forces acting upon each leg such as long Soybeans and short Wheat.

Trending nature - spreads trend more often than outrights, in fact spreads can trend even while the underlying futures are moving sideways. Price movements in spreads either widen or narrow in their price differential. As an example July/December corn spread, let’s say July corn price is $6.00/bushel; December corn is $5.00/bushel; the spread is priced at 1.0. That is, July is 1.0 full dollar over December. When the July price moves down to $5.75 and December moves down to $4.50 the spread has widened in price to 1.25.

Seasonal spread pattern – is the tendency for a particular spread to behave (price wise) during a certain calendar period every year. The historical price activity is then analysed looking for trends that recur in the same direction during a similar period of time. This data is collected over several years and in some cases the percentage of a recurring price within a particular time frame is greater than 80%. This statistical time frame to enter and exit a particular trade provides a real window of opportunity. Seasonal traders use history to figure out what time of the year they should enter and exit spread trades. Moore Research and Trader’s Almanac provide comprehensive explanations and examples of seasonal patterns www.mrci.com and www.wiley.com

Greater anticipation – you can plan spreads several days in advance and do not always need a technical indicator (MACD, RSI, oscillator etc) to trigger you into the trade. The time frame provided by seasonal patterns to enter and exit a spread is a real edge but even with highly favourable statistics strict trade management is required.

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