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Bull Spreads - Definition
Bull Spreads are futures positions consisting of being long a near term contract and then short a further term contract, profiting when the price of the underlying asset goes up.
Bull Spreads - Introduction
Spreading in futures trading is the most common way of reducing margin requirement and to hedge against directional risk of open futures positions. Also known as "Futures Strategies" or "Futures Position Trading", Bull Spreads are futures spreads used for profiting when the price of the underlying asset goes upwards. Bull spreads in futures trading are amongst 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 Bull Spreads are, their working mechanism as well as their pros and cons in futures trading.
What Exactly Are Bull Spreads?
When you are bullish on an asset, you would typically go long on its futures contracts in order to reap a leveraged profit when the price of the underlying asset rises. This is known as an "Outright Position". A Bull Spread is formed when you go short on longer term futures contracts on the same underlying asset on top of the nearer term long futures position that you are already holding. Yes, Futures Bull Spread is a form of Futures Calendar Spread.
So, a futures bull spread is formed when you:
Long Near Term Futures + Short 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.
Bull spreads are not only intracommodity spreads, they can also be intercommodity spreads by going long on the near term futures contract of one commodity and going short on the further term futures contract of another related commodity in commodity futures trading.
How Does Bull Spreads Make A Profit?
Unlike outright futures trading positions which make a profit only when the futures contracts that you own appreciates in value, futures bull 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 bull spreads profit primarily from a rise in value on the underlying asset, making the near term futures contracts appreciate 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 Bull Spreads?
There are two main reasons why Bull Spreads are being used; Increase In Profit Avenues and Lowering of Margin Requirement and risk.
Increasing Avenues of Profit
As you have seen above, bull 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, bull spreads are not only used for speculating in a rise in the spot price of the underlying asset but also on a narrowing of the spread between the near term futures contracts and further term futures contracts. 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 wide in relation to this pre-definable limit, a bull spread can be used to profit from the spread narrowing down.
Lowering Margin and Risk
Apart from increasing the avenues of profit, Bull Spreads are valued for their ability to limit risk. Bull 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 Bull 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 Bull Spreads
1. When the price spread between near term futures contracts and further term futures contracts are expected to narrow down in a normal market.
2. When the price spread between near term futures contracts and further term futures contracts are expected to widen in an inverted market.
3. Any market condition which leads to near term futures contracts rallying against further term futures contracts. An example of such a situation includes a short term lack of supply which pushes up short term demand per unit and price.
Advantages of Bull 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.
:: Bull Spreads are capable of profiting even when the underlying asset remains stagnant.
:: Bull Spreads lowers margin requirement thereby increasing your ROI.
Disadvantages of Bull Spreads
:: More legs take up more commission
:: Bull Spreads do not make the kind of explosive profit during a price breakout that outright futures positions can.