Futures spread trading has become very popular because it allows traders to bet on price movements while controlling their risk exposure.
Successfully executing this strategy requires a solid grasp of the underlying mechanics of spread trading.
To help you along, let’s explore the different types of futures spread trades, the advantages they offer and how you can quickly get started with your own spread trading strategies.
What is Futures Spread Trading?
Futures spread trading is a strategy that involves taking offsetting positions in a commodity to capitalize on price differences between two contracts, or to hedge against price movements in a particular market.
What Are the Different Types of Futures Spreads?
There are several different types of futures spread trades, including inter-commodity spreads, intra-commodity spreads, and inter-exchange spreads.
Inter-commodity spreads involve buying and selling futures contracts of different commodities, such as buying wheat futures and selling corn futures. Intra-commodity spreads involve buying and selling futures contracts of the same commodity, but with different expiration dates.
Inter-exchange spreads, which are less common, involve buying and selling futures contracts on different exchanges.
Some of the more popular spread trades involve assets/commodities such as:
- Natural gas and electricity
- Crude oil
- Fed funds and Eurodollars
- 2-Year T-Notes and 5-Year T-Notes
What Are Some of the Most Common Futures Spread Strategies?
- Calendar spreads – Calendar spreads, also known as time spreads or horizontal spreads, involve buying and selling futures contracts with different expiration dates, but the same underlying commodity. These spreads allow traders to take a position on the difference in price between the two contracts, or to hedge against price movements in the underlying commodity.
- Crack spreads – Crack spreads involve buying a crude oil futures contract and selling futures contracts for products refined from crude oil, such as gasoline and heating oil. These spreads allow traders to take a position on the difference in price between crude oil and refined products.
- Butterfly spreads – Butterfly spreads involve buying one futures contract and selling two contracts with different expiration dates, but the same commodity. These spreads are designed to profit from a narrow range in the price of the underlying commodity.
- Inter-commodity spreads – These spreads allow traders to take a position on the relationship between the two commodities, or to hedge against price movements in one commodity by taking an offsetting position in another.
- Inter-exchange spreads – Inter-exchange spreads allow traders to take a position on the difference in price between the two contracts, or to take advantage of arbitrage opportunities between the exchanges.
Understanding Futures Spread Margins
Futures spread margins act as collateral when entering into a futures spread trade. The margin requirement is set by the exchange and is designed to ensure traders can cover potential losses on the trade.
The margin requirement for a futures spread trade is typically lower than a single futures contract. This means that the trader is not exposed to the full price movements of either contract, and the potential for loss is limited to the spread between the two contracts.
Futures spread margins are often calculated based on the difference in price between the two contracts and the size of the position. The margin requirement may be adjusted based on the volatility of the underlying market and the creditworthiness of the trader.
Four Key Reasons to Spread Trade
- Risk management – Futures spread trading can be a useful tool for managing risk, as it allows investors to take a position on the difference in price between two contracts, rather than being exposed to the full price movements of either contract. This can help to limit the potential for loss and improve the risk-return profile of a portfolio.
- Arbitrage – Futures spread trades can be used to take advantage of price differences between two contracts, a strategy known as arbitrage. By buying a contract at a lower price and selling a contract at a higher price, investors can potentially profit from the spread between the two contracts.
- Hedging – Investors may use futures spread trades to hedge against price movements in a particular market. For example, an investor who owns a large position in a particular commodity may use futures spread trades to hedge against potential price declines.
- Speculation – Some investors may use futures spread trades as a speculative strategy, betting on the direction of price movements in the underlying market.
What Are the Main Risks to Keep in Mind for Futures Spread Trading?
Some of the most important risks associated with spread trading include:
- Market risk – The value of a futures contract is subject to fluctuations in the underlying commodity’s price. If the price of the commodity moves against the trader, it can result in a loss.
- Credit risk – If a trader enters into a spread with a counterparty and the counterparty defaults on their obligation to deliver the underlying commodity, the trader may incur a loss.
- Liquidity risk – Spread trading involves two separate futures contracts, and if one of the contracts is illiquid, it may be difficult for the trader to close out their position.
- Basis risk – The basis, or the difference in price between the two contracts, may widen or narrow over time. If the basis moves against the trader, it can result in a loss.
- Rollover risk –When a futures contract approaches expiration, the trader will need to “rollover” their position to a new contract. If the rollover is not executed smoothly, it can result in a loss.
How Can R.J. O’Brien Canada Help with Futures Spread Trading?
We hope you’ve enjoyed these futures spread trading tips.
Spread trading can become an integral part of helping achieve your investment goals – if you’ve got the right support system in place.
R.J. O’Brien combines world-class professional guidance and expertise with a market-leading trading platform with advanced tools and features.
If you’d like to hear more about how we can help you, contact R.J. O’Brien today.