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Futures Spread Training by Steven A. Mitchell Date: 02/11/10 Estimated Update: 02/18/10 Company: VTUniversity.com Phone: 800.462.4691 Website: VTUniversity.com

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 in futures spreading? 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 futures 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.

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