Last Updated on 19 September, 2022 by Samuelsson
There are different ways to trade the futures market, and spread trading is one of them. Both hedgers and speculators in the futures market use spread trading to their advantage. But do you know what futures spread trading is?
Futures spread trading is a futures trading strategy in which you simultaneously buy one futures contract and sell another to take advantage of the price difference. So, it is an arbitrage technique where you complete a unit trade with both a long and short position.
This post introduces you to the mechanism of spread futures trading. To make the topic easier, we will discuss it under the following headings:
- What is futures spread trading?
- How do futures spreads work?
- Types of Futures Spreads
- Bitcoin Futures Spread Trading
- Futures Spread Trading margins
- How to trade futures spreads
- Risks associated with futures spread trading strategy is spread trading profitable?
- Futures Spread Trading examples
What is futures spread trading?
Futures spread trading is a futures trading strategy where you take opposite positions in the same or related futures contracts. The idea is to reduce the risk, but at the same time, it allows you to profit from the pricing inefficiencies for one or several instruments.
Commodity futures spread trading is a lower risk approach to trade and can be utilized by any trader regardless of their level of experience. Futures spreads do not react to market moves the way pure future position does and can provide conservative addition to existing futures trading portfolio.
Spreads are always quoted as a single price and never as two individual prices. The price is calculated by taking the difference between the back month and the other month. As a spread trader, you want the gap between the long and short sides of the trade to be relatively big. That is, the difference in spread should be more positive in the long run.
How futures spread work
A futures spread trade happens when a trader purchases one contract while selling another simultaneously. The objective of futures spread trading strategies is to capture the difference between the price of the contract that is being sold and the one that is bought. This difference is what is known as the spread.
Some stakeholders in the commodity market use spread trading to hedge their risks, while speculators trade spreads to make gains. Since spreads are always quoted as a single price, there are two ways to trade spreads:
- Buying the spread: Buying futures spread simply means that the difference in price between the two contracts is expected to widen. A trader buys the spread by taking futures contracts that would allow for a significant expansion in the spread.
- Selling the spread: Selling futures spread means that the difference in price between the two contracts is expected to contract. That is, when a trader expects the spread to reduce (contract or converge), he will sell the spread and makes money by how much the spread contracts.
Although these are the basic techniques to spread trading, other complex techniques exist as well, for example, some advanced techniques may involve taking two positions in the market or trading options. However, spread trading should not be confused with outright trading, whereby an investor takes just one position in the market — either buying or selling a contract.
Spread trading is less risky than normal trading but it is not as profitable as staking on one position in the market. This is because changes in spreads are very small compared to the actual price movement in one direction. Going deep into the basics of futures spread trading, one of the simultaneously placed opposite trades (the long or short side) would end in a loss but the profitable one is expected to be significant enough to offset the losses from the opposite trade.
One more thing, the margin required to execute a spread trade is lower than the combined margins needed to execute the two opposite trades if placed separately. The low margin requirement makes spread trading easier. However, spread trading is not completely risk free because each side of the spread may be negatively impacted by technical and fundamental factors in the market. The expansion and contraction of the spread may exceed the general movement in the market.
Types of futures spreads
Below are some of the types of futures spread you should know:
Intermarket futures spread
It is the least common method of futures spread trading. In this method, the trader simultaneously opens a buy and sell position in the same asset and of the same contract month but on different exchanges. An example of this type of futures spread is when you buy a July wheat contract on the Kansas City Board of Trade (KCBT) and short the same contract on the Chicago Board of Trade (CBOT) at the same time.
Intramarket futures spread
Also known as calendar spreads, intramarket spreads involve going long in one contract month and then going short in another contract month of the same security on the same exchange.
An example of this type of futures spread is going long Corn in November contract and going simultaneously short Corn in December contract.
Intercommodity futures spread
This type of futures spread is when you open opposite positions in two different commodities that are economically related.
An example is when you go long in March Crude Oil and short in June Heating Oil.
Commodity product spreads
This involves buying and selling futures contracts that are related to the processing of raw commodities. An example is the Soybean Crush, which implies going long on Soybean futures and short on Soybean Meal and Soybean Oil futures. With this, you are able to simulate the financial aspects of soybean processing — buying soybeans, crushing them, and selling the resulting soymeal and soybean oil.
Bitcoin futures spread trading
Bitcoin futures started trading in 2017. These contracts offer futures spread traders the opportunities to benefit from price volatility. For example, if a trader believes a price will go up over time, he can take a buy contract one month out and a sell contract two months out at a higher price. By exercising their option to buy in the one-month contract and then sell in the two-month contract, they benefit from the price differential.
Futures spread trading margins
Owing to less volatility (risk), margins are lower for futures spreads than for trading a single contract. For example, let’s say the outright margin for crude oil futures is at $3,000 and the outright margin for heating oil futures is $1,500.
Instead of posting $4,500 to trade a spread on these two contracts, you may receive a 75% margin credit; so, your initial margin would be $1,125, indicating the lower risk in spread trading the two contracts rather than trading each of them outright.
How to trade futures spreads
Although futures spread trading is not as risky as buying and selling futures contracts, futures spread trading still requires some experience and focus. In cases where a trader is trading intermarket futures spread, they should be aware of the requirements of the different securities.
The most important step to take before involving yourself in futures spread trading is to get yourself familiar with the characteristics of the different commodities and the primary factors affecting the commodities you are trading. Some of these factors are seasonality, the political environment, and so on. Also, you should check with your broker to know the margin requirements of each instrument you want to trade.
The risk associated with futures spread trading strategy
As with most things trading, futures spread trading is not completely risk free. Below are some of the risks that are associated with futures spread trading:
Many brokers don’t allow the use of stop loss orders in spread trading. Not using stops is a very big issue for traders because you will need to have a good trading plan and strong discipline to trade it. Since in this type of trading your stops are mentally placed, you have to close the trade with loss without any delay. Some brokers will allow stop orders, but still, you can easily be knocked out by intraday volatility.
Potentially higher margin in some cases
Futures spread usually require lower margin but not all spreads are recognized by brokers and there is no margin reduction. So you might have to pay the full margin for both sides (legs). It does not mean that your trade won’t work but you will need to have sufficient funds and, note, that kind of spread is usually more risky and volatile.
More difficult to understand
Another confusion exists in the complexity of futures spread trading. Price can be on the positive and negative side and you are trading contraction and expansion of spread. Some securities are priced in different ways and have different units of measurement and contract values. Trading spread is a bit harder than just buying some shares of a company, but you will learn with experience.
Because spread involves opening and closing two futures contracts, your fees will double. But because of the competition between brokers, it is not a big issue.
Easy to become overconfident
Seasonal spread strategies have a high chance of success. So it is easy for you to have a significant profit and become overconfident, which can be disastrous to your trading.
Is spread trading profitable?
Whether futures spread trading is profitable or not is a matter of how experienced a trader is. Because it poses less risk and low margin requirements, the profit potential is high if done correctly. On the other hand, using this strategy without learning how to do so properly could result in your account being blown.
Futures spread trading examples
For intramarket spread, let’s assume that you anticipate that the price difference between March and May Wheat futures contract will increase. When there is no expected decline in supply, the May contract will have a higher price than the March contract.
Wheat in March may be trading at $3.50 a bushel while the late contract in May, may be trading at $3.55 a bushel. The difference between the two futures contracts is $0.05 per bushel.
But since you anticipate a widening in the spread, you short a contract (one contract is 5000 bushels) for the lower price (March) and long one contract for the higher price (May). In this scenario, you have bought the spread, and these trades combine to allow for growth in the spread.
So, as March draws near and you are ready to close the contract, both contracts’ prices have risen, but as you expected, May has risen after. The earlier Contract (March) is now worth $3.6 per bushel while the May contract is $3.75, bringing the new spread to $0.15 per bushel. At 5000 bushels, this ten cents increase in the spread is worth $500 ($0.10 x 5000) between the trades.
But if the March contract was sold at $3.50 per bushel which cost about $17500 and you buy it back at $3.60 per bushel, that translates to a $500 loss because you bought it at a higher price ($18000) or $0.10 per bushel, on the short side.
To put it all together, the May contract was bought at the price of $3.55 a bushel and sold for $3.75. That results in a $1000 profit on the May contract which offsets the loss on the March contract and makes you some profits. So, your net return is $500.
You do not have to start looking for price relationships that can give you mouth-watering spreads. There are certain types of spread that are traded actively, they have been given nicknames and can be predictable, however not 100% of the time.
Some of these are the heating oil/gasoline spread, the corn/wheat spread, and the US Treasury bill/eurodollar spread (AKA the Ted). Market forces such as high-demand/low-demand seasonality and economic cycles help to make trading these spreads a perennial investment vehicle. However, a proper understanding of how futures spread trading works and how to use is necessary to unlock the full profit potential of this strategy.