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Bear Spreads - Definition
Bear Spreads are futures positions consisting of being short a near term contract and then long a further term contract, profiting when the price of the underlying asset goes down.
Bear Spreads - Introduction
Spreading in futures trading is the most common way of reducing margin requirement and to hedge the directional risk on open futures positions. Also known as "Futures Strategies" or "Futures Position Trading", Bear Spreads are futures spreads used for profiting when the price of the underlying asset goes downwards. Bear Spreads in futures trading are one of the favorite futures trading strategies that professional futures traders use but they are not without their pros and cons.
This tutorial shall explore in depth what Bear Spreads are, their working mechanism as well as their pros and cons in futures trading.
What Exactly Are Bear Spreads?
When you are bearish on an asset, you would have to go short on its futures contracts in order to reap a leveraged profit. This is known as an "Outright Position". A Bear Spread is formed when you go long on longer term futures contracts on the same underlying asset on top of the nearer term short futures position that you are already holding. Yes, Futures Bear Spread is a form of Futures Calendar Spread.
So, a futures bear spread is formed when you:
Short Near Term Futures + Long Further Term Futures
Actually, when you place a futures spread, you are taking on the risk in the pricing difference between the long and short futures contracts rather than a simple directional risk in one futures contract. This puts you in the place of both a speculator as well as a hedger, speculating on the price difference and hedging against risk at the same time, which is now known as taking the position of a "Spreader". Learn more about Futures Spreads.
Bear Spreads are not only intracommodity spreads, they can also be intercommodity spreads by going short on the near term futures contract of one commodity and going long on the further term futures contract of another related commodity in commodity futures trading.
How Does Bear Spreads Make A Profit?
Unlike outright short futures positions which make a profit only when the futures contracts that you own depreciates in value, futures Bear Spreads profit when:
1. When the long leg rises and short leg falls.
2. When the long leg rises and the short leg remained unchanged.
3. When the long leg rises and short leg rises at a lower rate.
4. When the short leg falls faster than the long leg.
5. When the long leg remains unchanged and short leg falls.
Yes, even though Bear Spreads profit primarily from a drop in value on the underlying asset, making the near term futures contracts depreciate faster than the further term ones, any of the above 5 scenarios can arise from technical reasons as well. Technical reasons being changes in the price of the futures contracts which is not directly due to a change in price of the underlying asset.
Why Use Bear Spreads?
There are two main reasons why Bear Spreads are being used; Increase In Profit Avenues and Lowering of Margin Requirement and risk.
Increasing Avenues of Profit
As you have seen above, Bear Spreads are capable of a higher chance of profit than outright positions due to the fact that there are more avenues of profit. In fact, Bear Spreads are not only used for speculating in a drop in the spot price of the underlying asset but also on a widening of the spread between the near term futures contracts and further term futures contracts in a normal market or a narrowing of the spread in an inverted market. The spread between the near term and long term futures contracts of most commodities trade within a reasonable limit defined by their carrying cost. When the spread is too narrow in relation to this pre-definable limit, a bear spread can be used to profit from the spread opening up.
Lowering Margin and Risk
Apart from increasing the avenues of profit, Bear Spreads are valued for their ability to limit risk. Bear Spreads are really trading the difference in price (the "Spread") between the long and short legs and such price difference tends to trade within a determinable range! That's right, this makes trading Bear Spreads a lot more predictable and subject the futures trader to much lower risk.
Apart from lowering the risk involved, putting on a spread also decreases your initial margin requirement dramatically. You could pay up to ten times lesser initial margin for a futures spread versus an outright position. This will enable you to put on a lot more positions for greater ROI! In fact, futures spreads are so effective that most futures brokers quote futures spread position directly for trading as if it is one asset on its own! These are known as "Ready Made Spreads".
When To Use Futures Bear Spreads
1. When the price spread between near term futures contracts and further term futures contracts are expected to widen in a normal market.
2. When the price spread between near term futures contracts and further term futures contracts are expected to narrow down in an inverted market.
3. Any market condition which leads to near term futures contracts dropping against further term futures contracts. An example of such a situation includes a short term lack of demand on the underlying asset which pushes down prices.
Advantages of Bear Spreads
:: Much more avenues of profit than an outright futures position, hence higher probability of profit.
:: Futures Spread prices are subject to seasonality and move within pre-determinable limits, making it easier to find good entry points.
:: Bear Spreads are capable of profiting even when the underlying asset remains stagnant.
:: Bear Spreads lowers margin requirement thereby increasing your ROI.
Disadvantages of Bear Spreads
:: More legs take up more commission
:: Bear Spreads do not make the kind of explosive profit during a price breakout that outright futures positions can.