Spread trading is very good for the smaller account traders after they figure out how to trade Spreads. The capital required to trade these Spreads is a fraction of an outright Futures contract. Figure 1 shows a comparison of a Corn Spread to an outright Corn position.
Spreads generally move much slower than outright Futures positions, thus reducing some of the risk involved. By combining the use of Spreads and Seasonal Patterns of Commodities, we can get that added edge that most traders don’t have. Spread trading is one of the best kept secrets on the exchange trading floors. Not many small traders follow these, but you can be assured that the large traders and commercial traders are looking at and using these Spreads.
Spread Trading has been referred to as “Hedge Trading.” Remember that Hedging is the method Commercial traders use to help reduce price risk volatility. They may own the physical Commodity and short a Futures contract against it, or they may need the Commodity at a later date and buy the Futures contract until time to purchase the Commodity in the cash market. In essence, Spread Trading involves being simultaneously long a position in a Futures contract and short a position in another similar or related Futures contract. To some degree, the long position is “hedged” by the short position.
Traders use Spreads to take advantage of seasonal events that happen each year on a regular basis. For example, in the Copper market, each year around March the building industry starts gearing up for their busy season. They start buying Copper products (electrical wiring, plumbing, flashing for roofs, decorative roofing, etc.) and this creates excess demand in Copper for the nearby months. This in turn causes prices to rise faster in the front months because the Commodity is needed right now and not later in the year. You could consider buying a front month of Copper and selling a back month of Copper. As the demand for Copper increases during this time of year, your Spread will widen, giving you a profit for the position (this is not a trade recommendation, but simply for educational purposes only). This is just one of the Seasonal events that occur every year. Some others are heating oil for winter, gasoline for driving, meats for barbecue season, etc.
This type of trading is not concerned with absolute price levels of the Commodity you are trading. Spread traders are, however, concerned with the relative pricing of contracts, speculating on price differentials between the two contracts. By establishing a Spread position instead of an outright Futures position, you are creating a trade that will usually have less risk involved – but not always.
As an example, the trader establishing this position – Long July Corn and Short December Corn – would not be worried about the actual price of these Corn contracts, but certainly would be watching the relative difference of July Corn and December Corn. If July Corn gains more in value relative to December Corn, then your position will be profitable. If, however, your July Corn decreases in value relative to December, you will have a loss in your Spread position.
Before entering the Spreads, I like to look at the individual Corn contract charts for relative strength to one another. This helps confirm strength on the contract I am buying and weakness on the contract I am selling. After entering the Spread, I only watch the Spread difference chart. You can look at Spread charts using either a line on close chart or candles. Both will give you good support and resistance levels, trend lines and other technical tools will work well, too.
In the Long July Corn and Short December Corn example, our trader stands to profit if any of the following five situations occur:
- The long contract rises in price, while the short contract decreases
- The long contract rises in price, more than the short contract
- The long contract rises in price, and the short contract stays at the same price
- The long contract stays the same price, while the short contract’s price declines
- The long contract declines in price, less than the short contract
Keep in mind that there is some risk in Spread Trading, too. If anything happens to our position other than the five steps above, we stand to lose on the trade.
Popular Exchange Traded Spreads
- Intra-market Spreads – Simultaneous purchase of one delivery month and the sale of another delivery month of the same commodity on the same exchange. Also known as Calendar Spreads.
Example: Buying July Soybeans and Selling November Soybeans traded at the CBOT
- Inter-commodity Spreads – Simultaneous purchase of one commodity and delivery month and the sale of another different but related commodity with the same delivery month.
Example: Buying December Canadian Dollar and Selling December Australian Dollar
Most all Intra-market Spreads receive the exchange recognized reduced margin rates. Some but not all Inter-commodity Spreads receive this reduced margin. Check with your broker or exchange first before establishing this position to see if it qualifies for a discount. The trade can still be done if not recognized, but you will pay the full margin on both sides of the position.
Being that Intra-market spreads are the least risky, they get the best reduced rate on margin reduction. Margin is based on risk/volatility and these spreads have much less margin than any other positions in the Futures industry.
The Inter-commodity Spread involving two different markets carries a higher margin rate due to the risk associated with using two different markets for your spread position. This type of Spread is the most volatile of the Spreads. These can actually be more volatile than the outright positions themselves.
Here are some current examples of margins for outright positions and Spreads.
As we discussed in previous articles about using margin and your Return on Investment, you can easily see how much less you have to pay out-of-pocket to get a good return percentage-wise.
With Spread trading, you give up some reward to gain insurance against an adverse move against you. Perhaps a news report or gap open against an outright Futures position could cost you dearly in slippage. With a spread, you would have a “hedge” to help protect from most of the adverse move.
Spreads can be charted much like any other market. They respond well to Technical Analysis. Whatever you’re usual charting methods are, you can easily use them with Spreads.
Most Spread charts are based on the close of the day. This creates a “Line” chart instead of your usual candlestick or bar chart. Figure 3 is an example of a Spread chart courtesy of Moore Research Center at www.mrci.com.
As you can see, Figure 3 has Support/Resistance levels, trend lines can be drawn, indicators can be added and time and price scales are the same as other traditional charting methods.
Here are some reasons why professional traders use Spreads:
- Lower Risk
- Attractive margin rates
- Increased predictability
Just because of their hedged nature, Spreads generally are less risky than outright futures positions. Since these prices are based on two different but related Commodities, they would have a tendency to move in the same direction together at different rates of change.
Since the margin levels are generally lower for Spreads, traders are able to trade a larger variety of positions increasing diversity. Also, due to the decrease in volatility, Spreads allow traders to risk smaller percentages of their account capital.
With a decrease in volatility, traders are able to hold positions for longer term price moves. With the hedge aspect, the trader is not shaken out by news events or adverse market moves as easily as an outright Futures position. Spreads are based on Seasonal factors such as cyclical basis and this adds yet another stabilizer and more predictive market behavior to Spread trading.
Don Dawson can be contacted at The Online Trading Academy