Spread Trading – The Alternative Trading Strategy
Spread trading has been around since markets and exchanges were first developed. Exchanges and their markets were designed not for speculation but to transfer risk from one party to another; speculation made them more efficient through increased volume and tighter price spreads (bid/ask). Commercial trading companies and financial institutions apply hedging (long/short positions) to reduce their exposure and offset risk to their principal underlying positions across every type of commodity or financial instrument. This risk-averse approach is the driving force to their market activity and success.
As a trader we can only speculate on price movement. In many markets, in particular futures, the price activity can be volatile and erratic. This can play havoc on your temperament and undermine your decision-making process. This is where spread trading has one of its greatest advantages – reduced volatility and smoother trends than outright positions. These two attributes are prevalent mostly amongst calendar spreads, which are identical contracts with different expiry months. This pairing of identical contracts with different expiry or delivery months acts as a built-in hedge and provides a trading edge. This is the way many professional traders or commercials trade.
Spread trading has traditionally been applied to commodity (futures) markets. A spread trade requires the trader to hold a long position and a short position at the same time in the same or similar markets. This article will present some of the key features to a spread strategy as well as the level of risk to various types of spread combinations. As mentioned, to understand how spread trading might benefit your bottom line you’ll need to know the other features beyond reduced volatility and smoother trends as well as the risk associated with different types of spreads. The least risky of spread trades are the calendar spreads.
Spread Trading – A Range of Possibilities
All markets can apply a spread strategy but the main point is to know the level of risk created by combining or pairing certain contracts. Let’s begin with calendar spreads (high correlation) which are the least risky of spread combinations and then move along the risk spectrum to the most risky type of spreads (low correlation). Your comfort zone for managing risk will determine your combination of (spread) contracts.
As mentioned, a calendar spread normally has the least amount of risk (for spreads) because the spread has identical contracts but with different expiry months. Generally speaking, spreads are a natural hedge, with less risk than an outright position but this is where a distinction must be made as we will illustrate. Spread trading is also referred to as hedge trading due to the nature of being long and short, especially in the same commodity i.e. calendar spreads, where you are more likely to have lower margin requirements, smoother trends and less stress in managing a position. The lower risk and volatility is evidenced by the lower margin requirements. An example is Copper, where margin for an outright position in a futures position is $5400 USD and a calendar spread in Copper is $304 USD or around 5% to that of the outright margin cost. In late April the September / December Copper spread moved 130 points or $325 USD whereas the (September or December) outright copper position over the same period had a move in excess of $6,000 USD. The point is that you can afford to hold multiple spread positions for far less capital (than an outright position) with greatly reduced volatility and leaves more capital to apply across other asset classes. The propensity to cut or close-out a losing trade is made easier when managing other spread trades that are profitable. This is all about managing risk within your comfort zone and staying in a groove. The charts below are for the September 2012 Copper futures and the other chart is for the September / December Copper spread for the same period.
Spread Trading - Trade to Your Risk
Let’s move along the risk curve to an inter-commodity spread. Here we have increased our risk by moving away from identical contracts (highly correlated) into semi or closely related (reduced correlation) contracts. In this spread, we will present October Live Cattle versus October Lean Hogs which are related, trade on the same exchange (CME) and therefore receive a reduced margin. This margin is reduced by around 30% to that of the combined or collective margin value of the two individual contracts. There is more risk compared to calendar spreads because they are not identical contracts and are therefore less correlated. The obvious risk is that each leg can go against you and this increased risk is reflected in the increased margin. For this reason some traders only use calendar spreads but as said earlier this is directly linked to your risk appetite. As an added edge to trading, especially in commodities are seasonal statistics. There has been much market hype in relation to seasonal statistics.