Trading Systems

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.  

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Fig1

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Fig 2

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.

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Fig 3

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.

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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

Jay holds a Diploma of Financial Services (FNS51004) from the Australian Financial Markets Association (AFMA) for the Generic and Specialist “Derivatives” knowledge and skills components of ASIC Regulatory Guide 146.

Just Spreads provide low-risk, low-margin spread trade opportunities and continuing education across a select group of U.S. and Australian futures markets. Just Spreads’ monitors only calendar spreads because of their unique and reliable trending nature. 

Jay has written a number of articles as listed below which can be found at 

Your Trading Edge, FN Arena and AHA Investor.

List of Articles:

An Introduction to Spread Trading - provides stock market investors with an introduction to spread trading as an alternative avenue of return

Spread Trading Could Be Your Trading Edge –spread trading is a powerful trading strategy that many retail traders have never heard of or know very little about. This article by Jay Richards was first published in the May issue of Your Trading Edge Magazine

Tale of Two Precious Metals - the investment community purchases gold and silver for different reasons. Typically they act as a hedge

Jay holds a Diploma of Financial Services (FNS51004) from the Australian Financial Markets Association (AFMA) for the Generic and Specialist “De...

moka2

Established member
529 13
Hello Jay
Is there any way to protect a Long or Short Calnder spread position?
The Calnder SPread Options are not liquid!
ANy synthetic way? using individual contract Options?
 

just spreads

Newbie
9 0
Hello Jay
Is there any way to protect a Long or Short Calnder spread position?
The Calnder SPread Options are not liquid!
ANy synthetic way? using individual contract Options?
Calendar spreads already have built-in protection because you are long and short the same commodity. The reduction in volatility is a form of protection.
I do not use options in any of my trading, only calendar spreads using futures contracts. Stay in markets that are efficient i.e. plenty of volume and open interest.
 

moka2

Established member
529 13
Calendar spreads already have built-in protection because you are long and short the same commodity. The reduction in volatility is a form of protection.
I do not use options in any of my trading, only calendar spreads using futures contracts. Stay in markets that are efficient i.e. plenty of volume and open interest.
Calender spreads although are hedged tardes as you mention .. they still have a downside risk
What I was refering to was hedging that risk using Options on Calender Spread called CSOs
I know there are flor traded CSO on Eurodollar Spreads and Oil spreads but finding hard to fidn a broker who knows them!
 

Oskeewow

Newbie
7 0
Calender spreads although are hedged tardes as you mention .. they still have a downside risk
What I was refering to was hedging that risk using Options on Calender Spread called CSOs
I know there are flor traded CSO on Eurodollar Spreads and Oil spreads but finding hard to fidn a broker who knows them!
You can get creative with butterflies, condors, or other "boxes" - spread one spread against the next. Just be careful as commissions go up and volatility goes down. Or if you want to use options, it is uncommon (but definitely not unheard of) to see a calendar "twist" without a significant move in the outright. So maybe buying the volatility on the outright would help.
 

just spreads

Newbie
9 0
I agree with the posting from Oskeewow that costs go up. Without some measured amount of risk and expectation then there is no trade opportunity. More importantly, you create an additional level of risk by involving options on top of a simple calendar spread unless you have a profound view of price and time for any particular calendar spread. Many professional and commercial traders do spread one one against another on large volume i.e. short DEC 12/DEC 13 vs long MAR 13/MAR14 on thousands of contracts.
 

moka2

Established member
529 13
So what about CSO?
I was thinking if Oil Calnder spreads are not that volatile why not do Covered call writing

Buy Oil Calnder spread
Sell CSO on the same spread

No body sems to know about CSOs
By the way OKseewow can you explain in simple terms what that means
My question is if things start going wrong for your Calnader spread position what can one do?
Just Spreads can you give a worked example of "short DEC 12/DEC 13 vs long MAR 13/MAR14 on thousands of contracts. " how it would work!
 

just spreads

Newbie
9 0
#1 There is merit in your idea of using CSOs but I do not use options.
#2 In all trades I employ a STOP loss i.e. a money STOP which is equal to the initial margin; or select a price/chart level and close out the position after two closes over that level; or you can 'fine tune' the exit/stop level as two consecutive closes over a selected price.
#3 short DEC12/DEC 13 Eurodollar spread and long the MAR 13/MAR 14 Eurodollar spread. Here you would be looking a a slight widening of the near-term US yield curve. This approach has even less volatility than holding either of the two underlying spreads and far less than any outright position. Hope this helps, keep up the good probe, if not come back and continue the dialogue.
 

Oskeewow

Newbie
7 0
As JS said, you can buy and sell consecutive year spreads. Or more generally, pick what size spread you want (3mo 6mo, 12mo, etc), and then how many months between the spreads. In the example above, you have 12 mo spreads (Dec12 - Dec13), 3 mo apart (Dec to Mar). In either parameter, more months causes more volatility. So you can plug and play and find a combination that feels right to you.

What I meant by commissions go up is that trading a spread trades twice as many contracts as an outright. Trading a butterfly or a box is twice again as many. So putting on the Z2-Z3 vs H3-H4 example takes 4 contracts, 4 commissions. But your volatility goes down, along with your expected gross profit per size. You might be able to take a one lot outright for 5 ticks over a couple of days, but a 3 month butterfly might only move 1 tick in the same timeframe. Depending on your rate, you might pay more than half your profit back in commissions. Moving to longer/wider dated spreads improves volatility and makes this less of a concern.

To trade thousands of contracts, you'd have to have a lot of capital. I think the point is that you can trade a lot more size than you'd be used to trading in outrights. A point of caution, though: you might think you're comfortable with the daily price swings in your chosen hedge, but your account marks to the settle price every night. And some commodities, especially in deferred contracts with low liquidity, can occasionally settle at unusual prices, leading to a significantly adverse print. Just be careful not to push your margin too much.
 

moka2

Established member
529 13
Hi Oskeewow I get your point about 4 comms and less volatility
When you say "To trade thousands of contracts, you'd have to have a lot of capital." you mean outrights or Spread + Spread ? in case of 2 spreads the margin advantage means you will need less capital not more for thousand's of contracts

I am stil surprised that hardly anybody knows about CSOs!
One broker told me that they are only traded in the pit hence he was not really interested in exploring it further!

Trying to mimic CSO is difficult ( in my limited knowledge)
Since any Calnder spread has 4 ways it can go against you it is difficult to cater for that by some sort of comibination of ETOs on individual contracts!
 

just spreads

Newbie
9 0
Well said - your follow up (commentary) is accurate and brings balance to the finer points of spread trading. It is important to understand something before you discount it or simply say no. This is the case of trading calendar spreads i.e. it just might provide the level of comfort for many that are losing money, over-trading and are emotionally tied to their trading. There is most likely a level of risk using spreads for all traders, as the article presents.

Generally speaking (as shown in the article) using a scale for risk from 1 - 10, calendar spreads e.g. copper, resides around the 2-3 level; inter-commodity (lean hogs vs live cattle) around 5-6 and inter-market (Brent vs WTI crude) 7-10. This is only a sample of the types of risk in futures spreads only. Of course when you employ options you add a new element to your risk task/management.
 

moka2

Established member
529 13
so js WHEN YOU PROMOTE Spread Trading how do you manage downside risk? only with stop loss?
 

Oskeewow

Newbie
7 0
Sure, it's less capital to put on 1000 butterflies than 1000 outrights, but depending on how your broker manages the margin credit, you might at times need the capital for that many spreads or occasionally the outrights, depending on how you plan to execute. The common spreads and flies are traded where all sides are guaranteed, but you may find trouble getting filled all the time. If you want to manually leg in via individual spreads or with outrights, you'll be on the line at any point you're not completely hedged. Also, when 1000 butterflies does go a tick or two against you, you need to be able to cover the drawdown. And if you need to get out in a hurry, it may be harder to unwind a large position. Not to be discouraging - just fully understand the mechanics before you get in too deep.

I understand your interest in CSOs - I just don't think it's a big market. One thing you can do is instead of trade the box directly, just trade the one calendar, but keep in mind its price relative to neighbors. If it moves adversely, hedge it with a neighbor to put on the box, rather than just stop out. Then you can wait for the box to bounce.
 

moka2

Established member
529 13
I was inly refering to Exchange Recognised combinations not Leg in and out
Any way
Re heding as a Box .. YOU MEAN HEDGE oen Cal spread with another not converting a Cal in to a Butterfly.. correct?
so
If DEC/JAN starts going bad hedge with FEB/MAR
Not with JAN/FEB ( which wil make it a butterfly! correct?
 

just spreads

Newbie
9 0
I manage the risk associated with calendar spreads by placing a money stop (usually equal to the initial margin) or a selected price/chart level on a close basis only. Even with the high propensity of calendar spreads 'rotating' in a range for the lifetime of the spread, it is important to have a point where the trade needs to be closed. It all depends on your risk tolerance.