What are spreads all about?

January 6, 2014 04:04 AM

An intra-commodity spread (or calendar spread) is long one futures and short another of the same underlying with a different expiration date. An inter-commodity spread is long one commodity and short a different commodity or futures contract. Both typically having the same expiration. Spreads can also be constructed with futures traded on different exchanges (inter-exchange spread). Often this is done using futures on the same or similar underlying contract, either to arbitrage or in the case of similar commodity or energy contracts, to create an exposure to price spreads between two geographically separate delivery points. In some instances for speculators, spread trading can offer reduced risk compared to trading outright futures. This is because the spread consists two correlated markets, which tend move in a similar fashion creating a hedge. For this reason, exchanges generally have lower margin requirements for futures spreads.

How can you make money trading spreads?

By playing a spread one may want the spread to widen or for the spread to narrow.  With a spread, you follow the relationship, or difference between the contracts, without having to pick a market direction. 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 and if you sell, the market must go down. With a spread trade, you can make money whether the markets move higher or lower. If the side you bought goes up more than the side you sold, you make money. If the side you bought goes up and the side you sold remains even, you make money. If the side you bought does not move and the side you sold goes down, you make money. If the side you sold goes down more than the side you bought, you make money. Finally, if the side you bought goes up while the side you sold goes down, you stand to profit even more. Of course, in the above scenarios if the reverse of what is described happens, you would lose money. As far as I know, there is no trading method that is risk free. However, spreads add flexibility and versatility to a trader’s arsenal, and generally with less risk.  The key here is to find a spread that has a favorable risk/reward dynamic which should be at least 2:1 in my opinion.

Positive elements of spreads

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. 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. Spreads trend and swing well; analyzing a chart one can utilize standard tools of technical analysis. 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 spreads, the possibilities are vast. Some benefits are using spreads as an alternative to using protective stops, 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 against you. 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. 

Negative elements of spreads.

Not all spreads are recognized by a given exchange as carrying lower risk. Hence, there may be no reduction in the margin requirements. And, in fact, some spreads do not reduce risk due to seasonal elements of certain markets. You will need to learn the concept of “widening” and "narrowing” and entering trades at either a positive or negative price, which at times may be confusing. Additionally pricing spreads, orders and liquidity can sometimes be confusing. 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. The absence of stops for spreads that trade over different exchanges may also be a disadvantage to traders. A spread trade involves two futures transactions so you will need to factor in the commissions and fees that go with both legs.

About the Author

Vice President of Managed Futures & Alternatives at RCM Asset Management, brings hands-on analysis and trading experience to RCM Asset Management clients. Mr. Bradbard has been creating and executing trading strategies for over 10 years, and he is a respected commentator on a number of futures and options markets. Mr. Bradbard regularly publishes market commentary and trading ideas, and he is frequently cited in articles covering the futures and options space, and the role played by commodities in a diversified portfolio.