From the November 01, 2008 issue of Futures Magazine • Subscribe!

Spread pros & cons

Spreads can be valuable and profitable, but they do have their downsides. Here are some basic pros and cons of spread trading:

Pros

•Spreads in commodity futures offer lower margin rates because they usually carry less risk.

•Spreads are usually less volatile and prices move less quickly, which can be good for beginners who may be intimidated by the speed and price fluctuations of a single outright trade in the futures market.

•Spreads offer unique hedging opportunities in a variety of commodities.

•Certain types of option spread trading allow the trader to pay less in margin, funding the purchased option with the sale of the other side of the spread, thus reducing initial costs.

•Money flows from index funds have created opportunities to profit from bear spreads prior to the published roll dates of the indexes.

Cons

•Spread trading has much higher transaction (commission) costs because you’re using more than one trading vehicle. That’s why it’s even more important for a spread trader to have solid entry and exit points. Every penny will count.

•Spreads are often not traded outright in some commodities and must be legged into, which can be tricky for a new trader.

•Spreads can be less liquid than other trades, which could prove to be disastrous if you’re trying to get out of a position in a hurry.

•Spreads have limited profit potential along with limited risk.

•Some long-held assumptions regarding how certain types of spreads move in particular market environments are no longer valid due to the effect of roll congestion from index funds.

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