Spread Trading, Part 1

Professional traders still trade spreads rather than outright futures and it remains one of the classic trading methods.

A futures spread is the simultaneous trading of one futures contract against another and there are good reasons why professional traders incorporate spreads in their trading plans, in many cases spreads offer trades that have less volatility and heavily reduced margins, while still having excellent profit potential. Spreads can also reduce the risk of larger than expected losses caused by limit moves or big gaps on unexpected news. The spread trader can still make profits even if the underlying markets moves contrary to forecast. The spread trader is only concerned that the spread itself goes in the intended direction regardless of what the underlying is doing.

The best spreads to trade are those that a quoted as spreads by the exchange and placed on the same ticket.

Three common spreads:

1.The intra market spread (also called the inter-delivery spread)

This is the most common type of spread involving both a long and short position but with different expiry months of the same commodity. They are referred to as bull spreads or bear spreads depending on whether the trader is buying or selling the front month of the spread.

A typical example is the New crop/Old crop spread in the grain markets.

The bull spread refers to being long, or having bought, the nearby contract and being short, or having sold, the deferred contract (the back month). It is called a bull spread for two reasons, the first is by having bought the nerby contract you are said to be bullish, and secondly because these spreads often perform best in bullish, demand driven markets. In these cases when the commodity is in short supply the nearby contracts can trade at premiums over the deferred contracts. The deferred contracts lag the nearby because they expect future production to offset short term supply tightness.

An example of a good market for a bull spread is in the grain market, when tight global supplies and unexpected production problems drive nearby contracts much higher than the back month contracts.

The bear spread is the opposite of the bull spread and refers to being short, or having sold, the nearby contract and bought, or being long, the back month contract. If you have sold the nearby contract you are said to be bearish on the spread.  If your analysis suggests that a market top is forming the bear spread is the right strategy. In this case the nearby contract will often decline faster that the deferred contract.

One variation of the intra-market or calendar spread that occasionally gives the trader an opportunity to outsized returns is the “carry charge spread.” The ‘carry trade’ as it is also known.

For storable commodities deferred contracts usually trade at a discount to the nearby contract, the difference is known as the ‘cost of carry’ or the cost of storage. There is a theoretical limit to the nearby discount, because whenever the price difference approaches the cost of carry, large commercial traders could take delivery, store it and then deliver against a forward contract. The cost of carry includes insurance, interest and storage. Whenever the spread differential between the two contracts is close to the estimated carrying charge there is very little risk on the trade.

2. The inter-market spread

This spread involves a long and a short position between two different futures market, on the same exchange. A popular inter-market spread is the corn versus wheat spread. These two commodities have historical or seasonal patterns that futures traders anticipate. Corn usually outperforms wheat in the first half of the year while wheat will outperform corn later in the year. Spread traders trade the corn/wheat spread in both directions.

In the energy market a popular spread in the heating oil versus RBOB gasoline spread. These two contracts have different annual usage patterns, the heating season and the driving season. The spread will favour one over the other at different times of the year.

3. The inter-exchange spread

Finally, this spread nvolves a long and short position in commodities traded on different exchanges. A popular spread of this type is the Kansas City Wheat versus the Chicago Wheat spread.

Managing a futures spread.

We prefer to trade those spreads that can be written on a single ticket, in other words the spreads that are exchange traded. They offer an attractive margin concession and can be executed on-line as a spread rather than two individual legs.

If entering a spread as two separate legs because your software doesn’t support exchange traded spreads you should monitor the spread manually and manage spread stops by closing both legs.

Forecast of future price changes

There are times, more often than many think, when changes to the spread have given advance notice of a major trend move in the underlying futures. If we think back to the major crude oil bull markets in past years, one which comes to mind is the move in 1998. Crude was trading at about $10.00 with a view that prices would fall even lower. Spread traders however noticed that ‘bull spreads’ were showing positive patterns and breaking off lows. This behaviour alerted traders that the bottom of the market might have already been reached. For the next 2 years crude oil entered a major bull advance.