|
|
What is a futures spread trade?
A futures spread trade is the simultaneous
purchase and sale of two different futures
contracts whose object it is to profit from
a change in the relationship in price
between the two contracts. Examples could
include the purchase of July Corn and the
sale of December Corn (intra-market spread),
the purchase of February Lean Hogs and the
sale of February Live Cattle (inter-market
spread), and the purchase of March Kansas
City Wheat and the sale of March Chicago
Wheat (inter-exchange spread).
Generally, it is the relationship between
the futures contracts that characterizes the
spread; and this is reflected in the
relationship and change in price between the
two futures contracts that make up the
spread. Exchange recognized spreads are
those that are accompanied by a lower margin
requirement because the exchange
acknowledges that there is less risk in
trading certain spreads than outright
futures contracts. For example, at this
writing (because margins are subject to
change), if you were to purchase a December
Live Cattle contract the margin requirement
would be about $1013. However, if you were
to sell a February Live Cattle contract at
the same time, your margin on the entire
trade would only be about $540. The reduced
margin acknowledges the lower risk in
trading a spread.
How can you make money trading spreads?
When you trade an outright futures position
there is only one way that you can make
money. If you buy, the market must go up. If
you sell, the market must go down. With a
spread trade, you can make money five
different ways. If the side you bought goes
up relatively higher than the side you sold,
you make money. If the side you bought goes
up and the side you sold does nothing, you
make money. If the side you bought does
nothing and the side you sold goes down, you
make money. If the side you sold goes down
relatively lower than the side you bought,
you make money; and if the side you bought
goes up while the side you sold goes down,
you can really make money. Of course, if the
opposite of what is described above happens,
you would lose money. There is no trading
method that is risk free. However, spreads
add flexibility and versatility to a
trader’s bag of tricks, and generally with
less risk.
What trading techniques are used to trade
spreads, and who uses them?
Interestingly, fundamental and technical
traders use the same techniques to trade
spreads as outright futures. Oil companies
hedge their investment in their product
trading crude against the distillates and
vice versa by analyzing fundamental data.
The same is true of soybean processors who
trade bean oil and bean meal against
soybeans in various combinations depending
upon fundamentals. Some fundamental traders
spread the storage carrying charge
relationships between the contract months
for the grains. Others use supply/demand
data to trade various intra-market and
inter-market meat spreads.
Professional floor traders who must make a
market in a certain commodity often find
themselves on the “wrong” side of a trade.
One of the techniques that they use to
diminish risk or turn a losing trade into a
winner is to immediately take the “right”
side of the trade in a different contract
month. That’s a spread!
Technical traders who only rely upon charts
and technical indicators also trade spreads
profitably. A spread chart looks a bit
different in that it is a line chart,
reflecting only closing prices (no bar
charts or candlesticks). However, most of
the same technical tools such as trend
lines, moving averages, stochastics,
momentum, etc. can be used to chart spreads.
Seasonal tendencies significantly influence
the predictability of spreads and they tend
to swing and trend like their individual
commodity components, but generally with
less volatility.
There are a number of charting services that
offer spread charts and some are free (Futuresource.com,
Britefutures.com). Others charge a fee;
however, they tend to offer more flexibility
and more charting tools (Geckosoftware.com
and Barchart.com).
What are the advantages of trading
spreads?
Lower risk -
The exchanges recognize that spread trades
have lower volatility and usually present
less risk than a straight futures trade.
This is reflected in lower margin
requirements. Thus, not only do spreads
allow traders to better control the risk of
trading, they also afford efficient use of
trading capital through lower margins.
Anonymity –
Spreads do not count on a particular market
to go up or down; rather, it is the price
relationship between two markets that
determines the success of the trade. Spread
trades operate in the “undercurrent” of the
market. Indeed, stops are not used in spread
trades (and generally cannot be used).
However, stops are not necessary due to the
lower volatility of the trade. Therefore,
“the floor” cannot run your stops, causing a
frustrating, premature exit from an eventual
winning trade. In essence, your trading
becomes “anonymous”.
Increased trading opportunities –
When you consider that spread trading
opportunities include not only the
commodity, but also the number of contract
months available to trade, plus the
potential for inter-market and
inter-exchange spread trades, the
possibilities are nearly limitless. When
trading straight futures the nearby contract
or the contract affording the most volume is
what is generally traded. With spreads, you
can trade one commodity in as many
combinations as are offered by the number of
contract months that are open for trading.
Responsiveness to technical analysis -
Spreads trend and swing well; and their
chart pictures respond to the standard tools
of technical analysis. You can see this
immediately upon looking at a spread chart.
Consistency –
Seasonal and other patterns are evident in
spreads and it is very satisfying to
maintain and manage successful trades
lasting weeks and even months at a time.
Flexibility –
Spreads can be used and managed in any
number of ways and for many purposes.
Although some techniques are for advanced
spread traders, they include using spreads
as an alternative to using protective stops
to trade futures; legging in and out of
spreads; and entering a spread as a
defensive measure to reduce or avoid the
catastrophic effects of a lock limit move.
What are the disadvantages of trading
spreads?
Not all spreads are created equally -
Not all spreads are recognized by a given
exchange as carrying lower risk. Hence,
there may be no reduction in the margin
requirements. Most often, this pertains to
inter-market and inter-exchange spreads. For
example, you could spread soybeans against
wheat, but you would likely be required to
put up full margins for both contracts in
this trade. It does not necessarily mean
that the trade might not work, but you would
need to be aware of the requirement for
increased funds in your account to cover the
margin.
Learning the concept of “widening” and
“narrowing”-
This can be confusing, but is easily
overcome with experience. The confusion is
created because when you enter a spread
trade it can be done at either a positive or
negative price (or conceivably at point
zero). If you enter a positively priced
spread you want the price to “widen” to make
money. That is, you want to have the prices
move farther apart. However, if you enter a
negatively priced spread (as may often
happen) you want the spread price to first
“narrow” to zero, then “widen” in order to
make money. The confusion can be alleviated
by simply looking at a chart and recognizing
that in order to make money in the trade the
price line must go up.
Pricing spreads, orders and liquidity –
Pricing spreads can be difficult when doing
“inter-market” or “inter-exchange” spreads.
Some commodities are priced differently and
have different units of measure and contract
values. For example, if you want to spread
soybean meal and soybean oil you must deal
with the fact that a soybean meal contract
is traded in 100 ton units and priced in
dollars per ton. A soybean oil contract
consists of 60,000 pounds and is traded in
cents per pound. Establishing a price quote
for placing an entry order as a spread in
this situation is difficult. For technical
traders, the decision to enter is based upon
the chart picture and an entry order is
placed for both commodities either as
individual limit orders or market orders. If
limit orders are placed, there is risk that
only one side of the trade may be filled.
This may be particularly true in illiquid
markets and contracts in deferred months.
Thought may be given to entering thinly
traded markets with a limit order and then
entering the other side of the trade at the
market.
Stops –
The absence of stops may also be a
disadvantage to certain traders. Discipline
must be used to establish a trading plan and
then execute it. Since actual stops are not
used in spread trading, if the spread price
hits the mental “stop” point, the trader
must have the discipline to execute the plan
and close the trade with a loss.
Transaction costs –
By definition, a spread trade involves two
futures transactions, and the commissions
and fees that go with them. However, should
you decide to specialize in spreads (or even
trade them only sporadically) you may be
able to negotiate a discounted rate for
spread transactions with your broker.
Spread trading could be your edge –
Every trader is looking for an “edge”.
Spread trading is not glamorous; and perhaps
that is a reason why most non-professional
speculators don’t trade them. However, if
you want to learn to earn steady, consistent
returns trading your hard earned investment
capital with a lower level of risk and
volatility, you might want to consider
learning about spread trading.
All traders should understand that trading
in the futures and or options markets is not
for everyone. All traders should understand
that there is substantial risk of loss when
trading futures and or options. All traders
should carefully evaluate whether trading in
the futures and or options markets is
appropriate for them, as such trading is
speculative in nature. When trading futures,
traders may sustain losses which may exceed
their margin deposits. Option purchases may
result in the entire loss of premiums paid
for such options. Past performance is no
guarantee of future success.
|
|
