Spread Trading – The Alternative Trading Strategy
The fact is that spread trading futures based on a seasonal tendency has been around for donkey's years and is used routinely by professionals and commercial traders. Seasonal statistics provide an expectation of price behaviour during a specific time period every year. Supply and demand figures, political issues and interest rates are factored into their decision-making. An example is where a brokerage firm touts buying heating oil futures (North American) in summer because demand will increase going into the winter months. Unfortunately this (obvious) factor is most likely reflected in the November and December futures prices. The same is true for other markets’ seasonal price patterns. Most commodities experience a natural cycle of supply and demand during the year which can lead to natural cycles in higher and lower prices because of the seasonality of supply and demand. The best part about seasonal spreads is we can review different markets that have well-known seasonality trends. We know that the historical risks are the historical performance and we can be confident that our trades are well thought-out with defined risk and reward parameters. Trading seasonal futures spreads can offer a substantial edge or benefit based on past performance but too many traders rely solely on these time frames to enter and exit a trade in the hope that high probability will work for them this year. Unfortunately, many traders have been handed severe losses to this simple but loosely managed approach. In all cases trade management is what will allow you to preserve your equity, minimize losses and maximize profits. And of course the less correlated the individual legs or commodities are the greater the risk. In our final example this will become clear.
At the far (extreme) end of the risk curve for spread trading are the closely-related contracts but with different delivery locations and traded on different exchanges. Again, the risk has increased to such a degree that you will most likely receive no margin concession even though you have entered into a spread. For many years (1999 – 2011) the spread price between Brent Crude oil (Atlantic North Sea) and West Texas Intermediate oil (WTI) traded in an 8 dollar range i.e. -4 (negative) to +4 (positive) see the chart below. While this spread price remained constant or in a range for many years the aspects to each oil contract i.e. location, processing and storage changed. This became tragically evident in 2011 when the spread price blew-out causing enormous trading losses to many of the long-standing, active traders in this spread.
In conclusion, to understand the benefits and risk in spread trading you need to know the key features of spread trading as compared to an outright which are reduced volatility and margins along with smoother trends. A majority of spreads are not held to the influence of large commercial involvement as with an outright and are less concerned with liquidity and slippage. Remember, the higher the margin means you have increased the risk (less correlation) in the two commodities or contracts you have selected. So just because you have a spread does not necessarily provide you with reduced risk, rather it depends on the pairs you have selected.
Jay Richards can be contacted at JustSpreads.com