From the December 01, 2006 issue of Futures Magazine • Subscribe!

Exploiting spread trades

Traders shouldn’t limit themselves to one way of thinking about the markets. Yes, there is something to be said for focusing on an approach until you have mastered it, but that doesn’t mean you should see the world through narrow blinders. Spreads can offer better risk adjusted returns. Not only do they reveal hidden profit opportunities, but they can be traded with all the tools you already employ.

Spreads are not complicated. Every futures hedge is a spread, and every futures spread is a hedge, unless it is being used as a speculation. When a spread trade is placed, the risk changes from that of price fluctuation to that of the difference between the two legs of the spread. A spread tracks the difference between the prices of the underlying and the futures, or between two futures contracts. When we trade spreads we are usually acting as speculators.

A spread in the futures markets is nothing more than the arithmetic difference in the prices of two futures markets. This difference is typically plotted in the form of a line chart (see “Torn between two markets,” below).

In this chart we see the price of May 2007 corn minus the price of March 2007 corn. This is known as an intramarket spread, which is a spread made up of two different contract months of the same futures market. This spread currently has a margin requirement of only $68.

WHAT’S IN IT FOR YOU?

Spreads can be plotted for any two futures contracts you care to plot. You simply go long one contract and short another contract in either a different month, market or exchange. However, not all spreads are created equal. For spreads to make some sense, there is usually some relationship between the two contracts being spread. That relationship is generally economic.

Most experienced spread traders are only interested in spreads that have a close relationship between the contracts traded. The reason is simple: On only these spreads will the exchange (or exchanges) offer reduced margins, which are one of the features of spreads that makes them so appealing.

These are the types of spreads for which exchanges usually offer reduced margins: intramarket, intermarket and inter-exchange. An intramarket spread could consist of April gold minus December gold. An intermarket spread involves two related but distinct futures markets, such as the euro minus the pound. An Inter-exchange spread might be Kansas City wheat minus Chicago wheat.

These types of spreads also make sense because they get to the heart of the purpose of spreads, which is the need to hedge. Hedging is both the economic and social justification for the futures markets. In the eyes of society and the law, it is the ability to insure stable prices that is the rationale that separates futures trading from outright gambling. A futures hedge is nothing more than price insurance.

WHAT SPREADS DO

Because every spread is a hedge, it serves both a social and economic purpose. Even governments encourage the use of hedging and conduct classes to teach about the benefits of hedging. Spreading, when used properly, takes away much of the gamble for both user and producer.

For speculators, spreads take much of the risk out of using the futures markets. The remaining risks vary according to the contracts involved. One way to assess risk in spreads is to look at the margin the exchange requires in order to enter the spread.

For example, the margin for a March minus May corn spread of the same year carries a low margin. March and May corn are both contracts for the same crop year, so the exchange listed margin is very low (currently it’s $68). Compare that with the $450 margin required for trading one outright corn futures contract and you begin to see why spread trading can be so appealing.

Even a spread between months of a different crop year for corn carries only a $101 margin requirement. When you realize that you can carry six same-crop-year corn spreads for the same amount of money you would need to trade a single corn contract, it’s clear that trading spreads offers the most efficient use of your trading capital compared with any other method of trading.

These lower margins, and by extension lower risk, exist because of the nature of related markets. For example, if futures prices are lower than cash prices, arbitrageurs will begin

buying futures at the lower prices and selling the underlying at the higher cash prices. Their buying of futures causes futures prices to rise. Their selling of the underlying for cash causes cash prices to fall. That causes the difference between cash and futures to become smaller.

Most people don’t like the idea of losing large amounts of money. Nevertheless, there are many traders in the futures market who take undue risks with their money and don’t realize it. Anyone who trades in futures without the full realization of what is going on is gambling, regardless of whether that person is a speculator, a producer or a user.

SPREAD MYTHS

If spreads are such an exploitable trading vehicle, then you would think more traders would use them. However, a common misconception is that spreads lack the one thing that traders need to make money: volatility.

Those who argue against trading spreads say that spreads do not move as much as the outrights do. This is a false impression. On equally scaled price charts a spread will appear to move less; however, all good traders know that the real profits are in percentages, not the arbitrary values that appear on the vertical scale on your trading screen.

We’ve discussed how an intramarket corn spread can be six times cheaper to carry than a single outright position in corn. So, you have to ask yourself: Does a March-May spread in corn move six times less than a position in either of those two trading months (the difference in the price of margin)?

Consider this hypothetical trade. On April 11, 2006, you entered a spread long May 2007 and short March 2007 corn. The spread moved from a value of 3-1/4 to as high as 10 as of Aug. 1, 2006. This is a move of 6-3/4 points, or $337.50. Corn in the May outright futures moved from 270 to 281-3/4. This is 11-1/2 points, or $575.

Yes, the one spread made less money than the one outright position. However, for the same margin as the one outright trade, you could have placed six spread trades with margin money left over. Six spreads would have brought you $2,025.

At one point between April 10 and Aug. 1, the outright moved 18¢. Had you exited there, you would have made $900. This still isn’t as much as you would have made with the spread, and trading the May outright contract was a nightmare. It experienced a drawdown of 33¢ ($1,650) from the most profitable point before it made the 18¢. By Aug. 1, the outright May contract was actually losing money, having been entered at 285 and closing at 281-1/4. By contrast, the spread had a maximum drawdown of only $100.

MARKET TENDENCIES

The logistical aspects of the spread markets are nice, but there are other reasons to consider trades: spreads trend more often than the outrights and spreads trend longer than the outrights.

Years ago, prior to computerized trading, commercial interests controlled the commodity markets. There were no financial futures of any kind. The commercial interests knew how to milk a trend for all they could get from it. Markets trended for months, sometimes more than a year, both up and down. If your bias toward prices was wrong, you thought those trends would never end.

However, in the early 1980s it became possible to trade futures with the use of a personal computer. New money was attracted to the futures markets. Another attraction was the introduction of many of the financial futures markets during the 1970s. The new money grew and grew until it equaled and even surpassed the money of the commercial interests. The new money traded based on technical analysis instead of fundamental analysis, the way the commercial interests traded.

Instead of trending, the markets began to swing. Increasingly, short-term trading became more popular. As soon as a market was seen to be trending via technical analysis, a swing would begin. Before it could develop into a long-term trend, prices would be seen (via technical analysis) to be overbought or oversold, and so prices would begin to flatten out and then to swing in the opposite direction.

Of course, this is a generalization. Markets still trend when the underlying fundamentals of real supply and demand take effect. It’s just that markets in general don’t trend as often as in the past, nor do they trend as long.

But this isn’t true for spreads. Spreads still exhibit the long, extended trending moves that old-time traders remember from the 1970s and earlier. Reduced margin spreads can be implemented in virtually every market. You can do them in energies, metals, grains, financials, stock indexes, softs and currencies. The big trend moves are still out there as long as you know where to look.

Certain market trends in the underlying can be exploited through spreads. There are bull spreads and bear spreads, which tend to work when the underlying market is moving in a certain direction. But even these fundamentals change through time (see “Bear spread strategy takes toll on wheat pit,” entitled “Long opportunities,” in the November 2006 issue).

While lower margins for spreads allow you to make a bigger bet, it is not wise to use all the excess margin. Spread traders talk about a basis, which refers to a “normal” differential between markets. Arbitrageurs attempt to profit when that basis gets out of whack. When differentials become extremely volatile and the basis moves far from historical norms, a trader must understand that the spread is less hedged and must be careful with leverage.

Joe Ross is CEO of Trading Educators Inc. and president of Traders University. Ross has written 12 books on trading and has decades of trading and teaching experience. Reach him via his Web sites at www.tradingeducators.com and www.spread-trading.com.

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