Futures Spread Trading 101 – Your Journey Begins Here

Futures markets have been around for 200-plus years. They are allowing commercial entities to manage risk by hedging and speculators to take on risk for an opportunity to make a profit. For as long as futures have been trading, there has been a trading vehicle called Spreads. Many retail traders are unaware of Spreads and the benefits of using them. Commercial traders, large speculators, and managed money have known this best-kept secret for many years. 

Let me let you in on this secret and share some of the basics of trading Spreads. 

Hedging 

Hedging is done by commercial entities that use the physical commodity daily in their line of work. The two types of commercials are producers or processors/refiners of a commodity. 

A hedge is when commercials own the physical commodity (is long the cash product), and there is price risk exposure to the downside before they sell the cash product. A commercial offsets this price risk by selling a futures contract (short futures) and staying short futures until selling the cash product. 

A hedge allows the commercial to lock in a price between futures and cash, referred to as basis. Due to the nature of a hedge, the commercial is simultaneously long and short in the same market, using the cash product and a futures contract for price protection. 

Financial markets also use hedging to protect against risk. A money manager of a stock portfolio will be long stocks. Instead of selling all the stocks if the market turns down, he may choose to short (sell) stock index futures or use options to hedge downside price risk. 

Spreads

Speculators do not own the cash product and don’t need to hedge cash price risk. Their trading style usually is an outright long or short position in the futures market, exposing them to volatile price movements while attempting to make a profit. But, speculators in the know are aware of Spreads.

Spreads allow speculators to hedge a position to reduce price volatility and possibly receive a higher return on investment (ROI) than an outright futures position.

Types of Spreads 

A Spread is defined as simultaneously having a long and a short position in the same or related markets. 

The two popular types of Spreads are: 

• Intra-Market
• Inter-Market 

The least volatile of Spreads is the intra-market. An intra-market Spread is simultaneously long and short in the same futures market but in different expiration months. 

Intra-Market Spreads take advantage of the different demand periods of a commodity throughout the year. 

For example, the copper market:

• In November, a popular spread is to buy the March copper contract for the next year and sell the December copper contract for that same year.
• Both contracts should increase in price during the high demand period for copper due to the spring building season. The March contract that you buy should go up more than the end of the building season December copper contract. 
• If the seasonal pattern works, you will make more money on the March contract than you lose on the December contract. 
• All Spreads have two legs (long/short contracts), and a trader constantly loses on one leg and wins on the other. 

Due to the lower volatility and risk associated with an intra-market Spread, the required margin to trade is usually 25-30% of the outright legs combined. A trader can find the required margins on the exchange website that the products trade. 

Inter-Market Spreads can use multiple related markets to make up the Spread. The more common inter-market Spreads use two markets. More advanced Spreads called Crush and Crack Spreads require three individual markets. 

For example, the 10-Year Treasury Note and 30-Year Treasury Bond (NOB Spread)  

• Both markets must be economically related to be eligible for the reduced exchange Spread margins. You can Spread live cattle and the Japanese Yen, but you will pay the total margin, not the reduced exchange margin. 
• The Notes over Bonds spread (NOB Spread) is used to speculate on the yield curve. If you believe interest rates are rising, you buy the 10-year and sell the 30-year. If you think interest rates are falling, you sell the 10-year and buy the 30-year. Both of these choices create the NOB Spread. 

Inter-Market Spreads require more margin due to their volatility and additional risk. Typically the margin is about 50% of the outright contracts of the Spread. 

Intra-market Spreads allow protective stops to be placed on the platform; inter-market Spreads do not. Inter-Market Spread contracts are more likely that long and short contracts can go against the trader. Therefore, increasing the risk of using inter-market Spreads. 

Benefits of Spread Trading; Margin, ROI, and Risk Management 

Let’s look at the crude oil (CL) contract and compare their Spreads to outright positions. 

When trading Spreads, it takes one long futures position and a short futures position to make one Spread contract. Currently, the margin to trade one CL contract is $8,450. To trade an intra-market CL Spread, the margin would be $725 per Spread. 

Margin is determined by risk to the broker/exchange. Risk can partially be defined by volatility. The CL daily average true range (DATR) is $4.05 per barrel. The CL contract has 1,000 barrels making the average dollar range in CL $4,050. The intra-market Spread currently has a DATR of .20 per barrel, making the average dollar range $200. The intra-market Spread only moves 5% of the outright CL contract daily, reducing the risk and margin required to trade a Spread. 

A trader seeking a possible higher return on investments (ROI) will enjoy Spread trading. If a trader receives a profit of $1,500 in the CL contract, their ROI is 18%. If a trader has a profit of $1,500 in a CL intra-market Spread, their ROI is 207%! Using this formula: ROI = Net Profit / Margin X 100%.

While Spreads are considered less risky than outrights, they do have some risks to consider:

• A Spread can still go against a trader if some extraordinary event happens. For example, the Ukraine war initially put fear in the nearby grain markets, causing the front months to go up faster than the back months. If a trader was short the front month and long the back month, that initial surge could have caused significant losses if the trader did not have a protective stop. 
• Due to the small margin requirements to trade Spreads, traders could quickly get over-leveraged. The key is to diversify in different markets using Spreads, don’t bet the ranch on one Spread market. 
• Treat Spreads just as seriously as you would an outright. Generally, Spreads move slower than outrights, leading to complacency while managing a Spread. 

Charting Spreads

Depending on your charting package, you may have candles or bar charts representing the Spread range, showing an open, high, low, and close. Or, your chart package may only have a single line on the chart that is called a Line on Close chart (LOC). 

Some Spread traders use price action and trend lines to identify trading setups. In contrast, others may use traditional technical analysis. 

Intra-Market corn Spread between December and March contract. Notice how well Spread charts trend. Instead of candles, this chart uses LOC. These charts are available on Barchart.com.  

Commissions 

When trading Spreads, you will have two futures contracts that make one Spread contract. But, your broker will charge you a commission for each futures contract of the Spread. 

Should You Learn More About Spreads? 

Source: CMEGroup 

The table above is the weekly Commitment of Traders (COT) report. The legend shows Long, Short, and Spreading positions by managed money. The history goes back one year. Notice the Spreading category are the green bars. Reflecting that managed money has more Spread positions in crude oil than outright long or shorts. 

Summary 

Spread trading has been around for a long time. Spreads are better traded for longer durations than day trading. With the volatility of the outright markets today, you may consider learning more about Spreads to help tame this volatility. The lower margin requirements will allow for more diversification across different markets. 

This article was written as educational content and not meant to be used as trading advice or recommendations. 

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