In spread trading a spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts.
A spread trade always occurs when an investor or trader simultaneously buys and sells two related securities that are bundled as a single unit. There are possibility to create both of transactions individually. Each of the transactions is referred to as a “leg.”
In spread trading we track the difference between the price of whatever it is you are long and whatever it is you are short means the difference between the two contracts that are you holding.
Like the Normal trading risk in the spread trading changes from that of price fluctuation to that of the difference between the two sides of the spread it may shrink or may become wide with the count of time.
In the spread trading the main purpose is to net a profit from the difference in the two legs — known as the spread.
In the current trading environment with most of brokers Futures and options typically form the legs of a spread trade.
Spread trading brokers makes the arrangements to executed a trade as a single unit on futures exchanges in order to
A) ensure that the completion of the trade is perfectly synchronized the means trades are executed at the same time and on related assets.
B) It also makes it sure that both of legs are executed which eliminate the risk of one leg failing to execute.
and C) the Benefit/advantage which comes from the narrowing or widening of the spread.
Common Types of Spread Trades
1. Calendar Spread
2. Intercommunity Spread
3. option spreads Spread
This is also known as intermarket spreads because these are created as the calendars in the same market but in different months.
A good example of calendar spread is you are long on July Wheat and short on December wheat.
Basically, calendar spreads are executed while keeping in view the expected market performance of a security on a specific date, versus its performance at another point in time which also remain specific, like the example quoted above.
This type of spread trading is also known as Intermarket spread commonly and it can be done by going long futures in one market, and short futures of the same month in another market.
So easy to understand the intercommunity spread trading where markets can be different but months should be same to trade. A good example can be you care short May Corn and Long May Wheat.
Intercommunity spreads can become calendar spreads by using long and short futures in different markets and in different months which is another option for trader to make money from spread trading.
Intercommunity spreads mirror the economic affiliation between two changed but comparable commodities. Like the relationship between gold and platinum.
This is also known as Inter-Market spreads which is a less commonly known method of spread trading. In which spread is created via the use of contracts in similar markets, but on different exchanges.
In the third form of spread trading the spread is designed by buying and selling the same stock at different strike points. Like the (iron butterfly, iron condor, etc). The markets are similar, but exchanges are different.
A spread trading trader whom we call spreader is a trader who always positions himself in-between the speculators in the market and hedger.
Which always create best opportunities for him to earn from the different in spread.
Spreader always remain away from the excessive price fluctuation.
Because taking risk on the different months of the same future always decrease the risk stabilize the returns.
Spread trading need less time
When you are trading the spreads there you do not need to look at the spreads all the day.
One other benefit is you do not need real time data and the most important advantage is spreader trade the perfect trading instrument.
The most successful spread trading traders use EOD (end of day) data therefore spread trading is the most easy and profitable way of trading with the use of EOD that will hard take minutes in a day to plan and execute the trades.
If one cannot watch the trading screen whole day then spread trading is the best choice for him.
As with the daily routine of 30 minutes he can manage his portfolio. And the best thing which every one like most is the results which are considered are end of each day. It also saves the data cost as trader can get free EOD from every exchange.
Spread trading is easier to trade as spread tend to trend much more dramatically than the future contracts. The noise of the market which is caused by the computerized trading is totally eliminated in this type of trading.
Lower Margin means More Positions
Spread trading have less margin requirements which enable spreader to take more positions and margin trading always result in the better profitability.
Majority of brokers offer to trade on margin that simply means for spreader to earn more with any of broker as spreads give higher return on margin.
Spread trading offer a lower risk
I believe that it is the most conservative form of trading. When you compare it to other trading market you will find that this is safer then the other trading.
Obviously the risk is taken but it is very less as compare to the price risk taken in an outright speculation.
The Truth is Hidden
Professional trader does spread trading every day as it is most easy and risk-free trading for them. But in the retail industry no one knows about it because the truth is hidden from the world.
The truth was remained hidden over the years but now a day everyone starts talking about it and it is getting popularity among retail traders.
For the long time it is being commonly done by the market insiders and a lot of efforts are made to hide this technique from the retail trader. But now the time has come when every trader starts querying about it.
So, the distinct advantage of the insiders will be ended in the near future.
Specially the institutional traders who are aware of currency and systemic risk. They always look for alternative strategies to reduce this risk.
And I know many of them turn to spread trading which is also known as pair trading because this is the less risky trading method to earn from trading.
HOW ARE FUTURES SPREADS PRICED?
These are quoted as the difference in price between two contracts. The futures price of the “near month” minus the “deferred month”. For example, Sept vs. Dec Corn Spread. Sept Corn is trading at $5.1375 and Dec Corn is trading at $5.0000.
Near Month – Deferred Month = Futures Spread Price
September Corn – December Corn = Sept/Dec Spread Price
$5.1375 – $5.0000 = $0.1375
The spread price is encouraging because the near month is trading over the deferred month. Which results in the positive end.
Two basic Approaches of Spread trading
1. Seasonal Spread trading
2. Non-seasonal spread trading
Seasonal futures spread trading
Seasonal supply and demand matter in this type of trader. The spreader take his positons on the basis of comping demand and supply while keeping in view of two related contracts.
As we know there are market which have seasonal cycles and spreaders traders always love to trade in those market like commodity market. Spreaders take full advantage of seasonal patterns of this market.
As you know well seasonal patterns also exist in the Live cattle and Lean Hogs market.
One thing which support their decision making is seasonal patterns which are accessible from the market and by different data providers by analyzing that patterns spreaders can place a really good trade.
Non-Seasonal Spread trading
You may consider it other type of trading just nearly similar to our normal currency or stock trading.
In this method spread trading traders prefer to trade the future contracts of most commonly traded assets lie NASDAQ against Emini S& P. Many other similar contracts are also available.
Also Read About: Swing Trading Strategies
Pros vs. Cons In short
The value and importance of the sprad trading is really at edge because it offer low risk trading. Advantages which it offer are not possible anywhere else in trading. I decide to make a list of Pro and Cons too which are listed below,
- Less margin is required for spread trading.
- Trader can stay away from the stop loss which usually stop out them on stocks and currency market.
- Not as much of risk is involved in spread trading.
- Even Less time is required to make trading decisions by spreader.
- Spread betting is a less volatile concept.
- It is good to trade for beginners.
- If offer hedging opportunities in number of commodities.
- Less initial cost is required to start spread trading.
- Rolling future positions forward is possible in spread trading.
- Futures spread trading allows traders to take advantage of medium to long term moves with less capital.
- Spread trading also saves the data cost as only EOD is required to analyze the market and spreader can place trade without real time data.
- You can enter and exit with the actual spread order or with the independent leg (separate order for both contract).
- Offer decent fills during the closing of market.
- Offers greater chance of winnings.
- It is best use of correlation.
- It can be done when the underlying assets are going sideways.
The very first one is transaction commission which is very high with all of brokers. Because you are trading more than one contract at the same time. Every penny will count so if you decide to get in take very precise entries.
- Spreads are often not traded, outright.
- This is less liquid market. If you are in hurry to get out from a positions then you will suffer the pain.
- Majority of time spread trading have limited earning potential. Because trade holding time is much longer in it.
- Trading in this way can be a confusing decision for new trader.
Example of Trade
My Final Words
So, no one knows when the next Greece is going to happen. Futures spread trading can helps to protect your risk against unexpected events and volatility. It may be confusing for you in the start but its best trading opportunity to cater the risks.
Useful resources of Spread Trading
An Introduction: Introduction of spread – YouTube
Learning Material FUTURES SPREAD EDUCATION