A spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts, called legs. A spread tracks the difference between the price of whatever it is you are long and whatever it is you are short. Therefore the risk changes from that of price fluctuation to that of the difference between the two sides of the spread. Spread trades are executed to attempt to profit from the widening or narrowing of the spread, rather than from movement in the prices of the legs directly.
Spread trades are executed to attempt to profit from the widening or narrowing of the spread, rather than from movement in the prices of the legs directly.
Spread is created by entering long and short position simultaneously. But trading futures, we can make various spread combinations:
- Intracommodity (Intramarket, Interdelivery, Calendar or Time) Spread – Compromises a long position in one contract month against a short position in another contract month of the same commodity on the same exchange. For example, Intracommodity spread is going long December corn and short July corn.
- Intercommodity Spread – Is made up by opening position in a different but economically related commodity. Example can be long February Crude Oil and short February Heating Oil.
- Intermarket (Inter-Exchange) Spread – The least common method of creating spreads is to open positions in same or similar commodity but on different exchanges. An example of an Inter-Exchange spread would be simultaneously long July KCBT (Kansas City Board of Trade) Wheat and short July CBOT (Chicago Board of Trade) Wheat. Another example can be Crude Oil on CME versus Brent Crude Oil on ICE (Intercontinental Exchange).
- Low time requirements – You don’t have to watch a spread all day long. This is what makes spread trading the perfect trading instrument for professional traders and beginners. And therefore, spread trading is the best way to trade profitably even if you do not want to watch or cannot watch your computer all day long (i.e. because you have a daytime job).
Even those who daytrade use these advantages to optimize their trading results at the end of their trading day.
You don’t have to watch a spread all day long.
- Trading opportunities – Spread trader makes profit from a change in the price differential between two futures contracts. This relationship can change, even when underlying markets don’t move. Spreads trend usually more often than outright futures, but other opportunities lie in the number of combinations of spread. We can combine different delivery months, commodities and even exchanges. These possibilities are nearly limitless and you can choose the best trading opportunities each day.
- Easy to trade – Spreads tend to trend much more dramatically than outright futures contracts. They trend without the interference and noise caused by computerized trading, scalpers, and market movers.
Spreads tend to trend much more dramatically than outright futures contract.
- Low margin requirements – Spreads have reduced margin requirements, which means that you can afford to put on more positions. For example, when you are long August Crude Oil, your margin is around 2500$. Short May Crude Oil requires margin around 3000$. But when you create spread Long August Crude Oil – Short May Crude Oil, the margin doesn’t sums up to 5500$. Spread margin is only 500$, about a 90% reduction. Why? Futures spreads are usually not as volatile as outright naked positions. The exchanges and brokers recognize that spreads carry less risk and therefore reduce margin requirements.
Futures spreads are usually not as volatile as outright naked positions.
- Lower risk – Spreading is one of the most conservative forms of trading. It is much safer than the trading of outright (naked) futures contracts. Obviously, the risk taken for the difference in price among related contracts is far less than the price risk taken in an outright speculation. This is because related futures will tend to move in the same direction.
It is much safer than the trading of outright futures contracts.
- No need of live data – You do not need real-time data. The most effective way to trade spreads is using end-of-day or delayed data. You can save up to $600 per month in exchange fees. And you can save all the money you would have had to spend for real-time data systems.
You do not need real-time data.
- Transaction cost – As spread involves opening and closing two futures sides, your commissions will double. But nowadays, with online brokers with competitive low commissions, it’s not big issue.
- No stops – The absence of stops can be a big issue for traders. You need to have a solid trading plan and discipline to execute it. Since stops are only mental, you must be able to close the trade with loss without hesitation. Some broker’s platforms accept stop orders, but you can be easily stopped out by intraday volatile moves.
- Higher margin – Not all spreads are recognized by exchange and have no margin reduction. Sometimes you have to pay full margin for both legs. It doesn’t mean that trade will not work, but you need to have enough of funds in your account.
- Learning concept of spreads – There can be some confusion in spread creation and trading. Price can be positive or negative and you are trading narrowing or widening of spread. Same spread can be written in different notations. Some commodities are priced differently and have different units of measure and contract values.
- Easily gained overconfidence – Seasonal spread strategies have a high probability of success. It’s usually easy to get some nice profit and consequently gain false confidence. Success rate can be even improved by averaging in your position (adding contract into your losing position). In the good times, you can easily achieve three digits percentual gain in one year. But the black swan (unexpected extreme event) will arrive and together with an overtraded account (thanks to very low margin for intramarket spreads), averaging in and only mental stop loss, you can blow your account in less than one day. Always keep your feet on the ground and watch yourself for the signs of overconfidence.
Always keep your feet on the ground.