Futures Spread Trading
by Rick Dawson
Introduction
Futures spread trading has always been a popular method of trading futures. However, many beginning traders focus exclusively on buying and selling futures outright. Spread trading is the preferred approach for many professional traders. By adding spread trading, traders can increase their opportunities and better manage their risk.
This article will focus on futures spreads instead of options spreads. A futures spread is the purchase and sell of futures contracts in related markets. (A spread is also created when a trader or hedger takes a futures position opposite an existing or potential cash or physical position. However, this type of trading – basis trading - is outside the scope of this article.) The two positions must have an economic relationship to qualify as a spread.
Futures may be spread between different:
Points of time. This is also known as a calendar spread. The same commodity is bought and sold in different months. An example of this would be an old crop / new crop grain spread where you're short July corn and long December corn. If you're short the nearby month it's called a bear spread. If you're long the nearby month it's called a bull spread.
Commodities. An example of this would be a long December corn / short December wheat spread. I would also include spreads between a commodity and its products in this category, such a soybeans versus soymeal and bean oil (crush spread) and crude oil versus gasoline and heating oil (crack spread).
Markets. An example of this would be a long September Minneapolis / short July Kansas City wheat spread. In this example, you're long spring wheat which trades on the Minneapolis grain exchange and short hard red winter wheat which trades on the Kansas City board of trade. (Note that September is the first new crop month in spring wheat whereas July is the first new crop month in winter wheat.)
Note that a spread may fit in different categories. For example, a spread between December Minneapolis wheat and May Chicago wheat would different markets and points of time. A spread may not easily fit in a specific category. For example, is a spread between 10-year and two-year notes a commodity spread because two commodities are involved or is it a calendar spread because it's really a trade involving interest rates at two different points of time? It really doesn't matter as long as there is an economic relationship between the two contracts. In other words, a spread created via a correlation study between orange juice and pork bellies doesn't qualify as a spread. Correlation is not causation.
Why Trade Spreads?
The components of “legs” of a spread tend to move together. This makes sense when one considers the fact that if there's an economic relationship between the two legs then the same market forces will push both up and down. The implication of this that when you spread trade you give up a certain amount of opportunity. But the compensating factors still make spreads an attractive trading approach.
Cons:
A certain amount of opportunity is lost
A stop order isn't available on except with a broker willing to take the order – probably on a “not held” basis.
Commission costs may be greater because multiple contracts are involved.
Pros:
Usually less volatile than an outright long or short position
Tend to have lower margin requirements
More amenable to fundamental analysis
Good trading vehicle for positional trading
Offer additional “trending opportunities”
I would like to focus on the last benefit of spread trading. Speculation wisdom usually emphasizes the importance of trading with a trend. The problem is that futures markets tend to spend a lot of time in consolidation or trading ranges. It's interesting in note that two markets may not show a pronounced trend but if you spread one against the other then a trend will emerge. For example, if you had sold July '08 cotton on the close of 20 March 2008 at 73.83 and covered on 29 April 2008 on the close at 69.25 would have gained 323 ticks for a $1615 profit on futures contract with an initial margin requirement of $2520. (See the chart below.) However, during this time July cotton had a high of 82.23 for a potential loss of $4200. If you're honest with yourself, would you have stayed in this trade? Probably not. And even if you did, would the stress and frustration been worth it? Most traders would not think so. A chart of December '08 cotton shows a similar story.
(please click on chart to open up larger version in separate window.)
However, once you spread December Cotton long against July Cotton short a much more tradeable trend emerges. On March 20th and April 29th this spread closed at 5.45 and 8.45 respectively for a 300 tick gain or $1500 on a spread with an initial margin requirement of only $420. Consider the chart below. Any trader would admit that this trade would be been a lot less stressful for a gain not much different than an outright short would have been.
(please click on chart to open up larger version in separate window.)
Conclusion
The components or “legs” of a spread tend to move together. This makes sense when one considers the fact that if there's an economic relationship between the two legs then the same market forces will push both up and down. Spreads tend to underperform strongly trending markets. However, markets tend to spend a lot time in consolidation ranges during with times spreads can offer more trends and opportunities.
Rick Dawson is a registered Commodities Broker with Common Sense Capital. See the website for contact information. Trade ideas and setups are available at the Pattern Report. There is a risk of loss in futures, options, and spread trading.
Here is a link to Common Sense Capital's website.
