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Futures Spreads - Definition
Futures spreads are futures positions consisting of both long and short futures contracts on the same underlying asset or related assets.
Futures 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", futures spreads are widely used for various purposes and greatly extends your futures trading profit possibilities. This is why futures spreads are so widely used and recommended by futures trading professionals worldwide. In fact, futures spread trading is such a specialised field in futures trading recently that people who specialises in them are known as "Spreaders" alongside arbitrageurs, speculators and hedgers to become the fourth type of futures trader in the futures market.
This tutorial shall explore in depth what Futures Spreads are, their working mechanism as well as the different kinds of futures spreading methods.
What Exactly Are Futures Spreads?
When you go into a futures transaction as either the long or the short, you are considered to be trading futures "outright". However, when you simultaneously take on the long AND the short over two different futures contracts of the same underlying (or related assets), you are considered to be trading futures spreads. Futures spreads are created when a futures contract of the opposite direction is added onto an existing futures position or placed simultaneously. Yes, spreading is performed when you have a long and a short futures contract in the same position at the same time.
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".
Why Use Futures Spreads?
There are two main reasons why futures spreads are being used; Increase In Profit Avenues and Lowering of Margin Requirement and risk.
Increasing Avenues of Profit
While going long or short futures contracts outright only earn you profits when the futures contracts you traded move in your predicted direction, futures spreads are really capable of profiting in 5 different ways:
1. When the long leg rises and short leg falls. This usually happens when the basis is extremely large on the far term futures contracts and the underlying asset moves up slowly.
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. This is usually what happens when near term futures with higher volatility is bought and far term futures with lower volatility is shorted.
4. When the short leg falls faster than the long leg.
5. When the long leg remains unchanged and short leg falls.
As you can see above, futures spreads greatly increases the avenues of profits even though it does not have the explosive potential of outright futures speculative positions. In fact, all of the above 5 points say only one thing and that is, futures spreads profit through the price difference of the long and short leg instead of the price action of the underlying itself!
Lowering Margin and Risk
Apart from increasing the avenues of profit, futures spreads are valued for their ability to limit risk. Futures 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 futures 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 due to developments in SPAN Margin. 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!
Types of Futures Spreads
There are 3 broad categories of futures spreads, the Intramarket Spread, Intermarket Spread as well as the Inter-Exchange Spread, which can then be categorised by function into either Bull Spread, Bear Spread, calendar spread or Butterfly Spread as well as by specific commodities such as the Crush Spread in soybean futures trading and the Crack Spread in crude oil futures trading.
Also known as "Calendar Spreads", "Intracommodity Spreads" or "Interdelivery Spreads". These are futures spreads using futures contracts of the same underlying but different expiration months. Intramarket spreads trade the price difference between futures contracts of different months on the same underlying. Due to carrying charges, there is usually a price range within which this difference can be thus making it easy and predictable to trade such futures spreads, using a bull spread when price difference is low and using a bear spread when price difference is high.
Another form of Intramarket Spreads is the "Intercrop Spread" which is a futures spread consisting of futures contracts of different harvest periods or "Crop Years".
Also known as the "Intercommodity Spread", are one of the most commonly used form of futures spreads in the commodity futures market by corporate producers. Intermarket Spreads are created using futures contracts of different but somewhat related underlying assets. Examples of related underlying assets commonly used in intermarket spreads are Gold/Silver, Soybean/Corn, Wheat/Corn, Soybean/Soybean Meal and Crude Oil/Heating Oil. Intermarket spreads are not only good for speculating on the price difference between two seasonally related products such as Gold and Silver, these futures spreads are also used by processors of raw material for locking in the profit margin involved in turning a raw material such as Soybean into its products such as Soybean Meal.
The huge depression in the profit margin of oil refineries in May 2010 demonstrated the importance of locking in profit margin through the crack spread, which is an intermarket spread between crude oil futures and gasoline as well as heating oil futures.
Also spelled as "Inter-exchange Spread". These are futures spreads consisting of futures contracts of the same underlying traded in different exchanges such as the Chicago Board of Trade (CBOT) and Kansas City Board of Trade (KCBOT). An example of an Interexchange spread would be simultaneously Long December Chicago Board of Trade (CBOT) Wheat, and Short an equal amount of December Kansas City Board of Trade (KCBOT) Wheat.
There are two main purposes in using interexchange spreads. One of them is to take advantage of price discrepancy in the same futures contract traded in different exchanges and the other is when a better price is available in another exchange for putting on a calendar spread.
These are futures spreads that are structured to speculate on a spread price narrowing when the underlying asset is expected to move higher. This is done by being long on near term futures contracts and short on far term futures contracts. Learn more about Bull Spreads.
These are futures spreads that are structured to speculate on a spread price widening when the underlying asset is expected to move lower. This is done by being short on near term futures contracts and long on far term futures contracts. Learn more about Bear Spreads.
These are any futures spreads that go long and short on futures contracts of different expiration months. In fact, there are calendar spreads for every of the three main broad categories of futures spreads. In fact, both Bull Spreads and Bear Spreads are calendar spreads as well. Learn more about Calendar Spreads.
These are futures spreads that consist of three legs instead of the traditionally used two legged futures spreads. It is a combination of a bull spread and a bear spread on the same underlying asset as a low volatility spread speculating on the spread difference of the futures contracts involved resulting in a change in term structure. Learn more about Butterfly Spreads.
Specific Commodities Spreads
Popular structured commodities spreads such as Crush Spreads and Crack Spreads are really intermarket spreads between related commodities.
Underlying Mechanism of Futures Spreads
Futures spreads work due to the difference in pricing as well as difference in rate of change in price of different but related futures contracts. Almost all futures spread strategies work based on being long and short futures contracts of different prices. Because of the difference in price and the fact that the price difference between futures contract changes due to the different rate of change in price between different contracts of the same or related underlying asset, there is profit to be made.
The price of futures contracts differ from month to month due to carrying charges and have different rate of change in price due mainly to difference in trading volume. Trading volume of near term futures contracts is generally higher than trading volume of far term futures contracts, resulting in near term futures contracts having higher volatility than far term futures contracts. This difference in rate of change in price also forms the underlying mechanics of what make futures spreads work the way they do.
Advantages of Futures 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.
:: Allows producers to hedge against production price risk.
:: Futures spreads are capable of profiting even when the underlying asset remains stagnant.
:: Futures spreads lowers margin requirement thereby increasing your ROI.
Disadvantages of Futures Spreads
:: More legs take up more commission
:: Futures Spreads do not make the kind of explosive profit during a price breakout that outright futures positions can.