Spread Trading, Part 2

Seasonal trading has been around since trading began and experienced traders use spreads because they offer benefits such as, higher probability of success, safety, longer trends, less volatility, lower margins and a hedge.

Seasonal patterns exist in most markets because of the production cycles, weather patterns, planting and harvest cycles. These patterns have been entrenched for years and are quite easily understood. Heating oil inventories are restocked at the time of least demand, unleaded gasoline consumption is strong after winter. More red meat is eaten in colder months and lean meat is eaten during warmer months. Gold is usually in high demand leading into gift giving season etc.

Spreads

A spread is the transaction of one futures contract at the same time as another offsetting contract. Spreads can be traded with either futures contracts or options. One of the important concepts of spreads is that the trend of either leg or individual futures contract is of no interest to the spread trader. A spread trader is only interested in the relationship between the sold (short) contract and the bought (long) futures contract.

Seasonal spread example.

Natural Gas.

As warmer weather nears in the northern hemisphere consumption of natural gas eases off. The decline usually drives near month, April, contract prices down while the back month contract, June, usually hold its premium, so we can reasonably expect the spread to widen.

Our trade will comprise of two hedged positions:

1. Buy June Natural gas (long)
2. Sell April Natural gas (short)

The simultaneous transactions creates the spread in which you are both long and short in the same market at the same time. Exchanges and brokers recognise that spreads carry less risk and therefore require less margin to hold the open spread. It doesn’t matter if natural gas trends up, down or sideways as long as the spread moves in your favour, in this case to widen.

With so many spread available one has to ask why more traders are not taking advantage of the benefits of spread trading.

Here are a few examples of seasonal spread trades.

January

Lean Hog Spread - Buy July Lean hogs/Sell April Lean hogs

Demand for Lean Hogs increases going into the northern summer, so prices for the "back month" (July) usually carry a premium over the "front month" (April) as the US consumes more lean meat over summer.

February

Crude Oil Spread - Buy June Unleaded Gasoline/Sell June Crude Oil

As the northern summer approaches crude oil demand rises a refiners switch from producing heating oil to RBOB unleaded gasoline. Retail demand for heating oil usually starts to decline.  The end of winter signals the start of the official driving season in America.

We encourage all traders to look closely at the benefits of seasonal trading and also seasonal spreads. In addition to the benefits listed above spread trading is an efficient use of time as it does not require constant monitoring, unlike outright futures positions.

The above information is general in nature and is not a recommendation to buy or sell any futures contract.