Q&A
Futures For You
Inside The
Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today's futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
On Spreads
What is a futures spread?
The terminology involved in futures spread trading often seems like a foreign language. This can cause those who aren’t familiar with the practice to misinterpret the vocabulary. Despite the complexity of the topic on the surface, once you understand a few key concepts, you will gain an immediate understanding.
A futures spread is a trade in which opposite positions are taken in similar futures contracts. Simply put, it is the purchase of one commodity and the sale of another related commodity with the intention of profiting from changes in the spread, or differences in the relation of the two prices.
The most commonly used spread strategy is the intracommodity spread (or calendar spread). Specifically, this entails a long position in one contract month of a specific commodity and a short position in another contract month of the same commodity. For example, a trader may buy a June 2009 eurodollar futures contract and sell a September 2009 eurodollar. (For those unfamiliar with eurodollars, I am referring to an interest rate product and not the euro currency. A eurodollar can be thought of as a certificate of deposit purchased with US currency from a foreign financial institution.)
Buying and selling spreads
What does it mean to buy or sell a futures spread and how does the position generate a profit or loss?
To accurately talk about spread positions with your broker, or even converse about them at a cocktail party, you must understand the difference between buying and selling a spread. This can be confusing; after all, a spread trader is both long and short a contract. However, the distinction is relatively simple; whether a trader is long or short, a spread is dependent on the position taken in the most valuable contract.
For instance, if a trader goes long the June 2009 eurodollar at 98.75 and goes short the September 2009 contract at 98.50, he is said to be buying the spread because the contract purchased is trading at a premium to the contract sold. Assuming fills at the prices noted, the spread could have been bought for 0.25, figured by taking the difference between the prices of the two contracts (98.75 — 98.50). On the contrary, if the same trader were to sell the spread, he would have sold the June 2009 contract and gone long the September 2009. Keep in mind that identical to trading outright futures, it is necessary to execute an equal and opposite position to the original when exiting a trade.
A spread trader is inherently hedged simply because they are both long and short contracts in the same commodity. Under normal circumstances, as the market rallies, the trade will be making money on one side of the spread and losing money on the other.
In theory, spread trading provides exposure to price movement with relatively less risk than an outright futures strategy. However, this isn’t always the case. In certain market conditions, spreads can make dramatic moves. In extreme cases it is possible for a spread trader to lose on both sides of the trade!
You may be wondering how a spread trader can make or lose money if they are both long and short a market. Which way would a spread trader want the market to go? The truth is, spread traders often do not have a directional bias; instead, they are interested in the relationship between the two contracts involved. Their concern lies in whether the difference between the price of the two contracts expands (widens) or contracts (narrows).
Spreads can be confusing, so here are a few simple and helpful rules:
- If you buy a spread (go long the higher-priced contract), you are anticipating that the price difference between the two contracts will widen. Should this occur, the spread would be profitable.
- If you sell a spread (go short the higher-priced contract), you are anticipating that the price difference between the two contracts will narrow. Should this occur, the spread would be profitable.
These rules will always be true regardless of the overall market direction, or which contract is trading at a premium (back or front month). If you can remember these concepts, you shouldn’t have any problems speaking with your broker about futures spread trading.
In order to support the premise of the rules, let’s look at our eurodollar example again. The trader who purchased a June 2009 eurodollar futures contract at 98.75 and sold a September 2009 contract at 98.50 would have done so with the expectation of a wider spread. At the time of execution, the spread was 0.25 so if the price difference between the June and September contracts widens to 0.30, the trader would be profitable by 0.05 points. Each point in the eurodollar is worth $25 to a trader, so the unrealized profit would be $125.
Once again, the spread may widen in a rising or declining market. Had the June contract rallied 10 points to 98.85 but the September contract only rallied five points to 98.55, the new spread would be 0.30 (98.85 — 98.55). Similarly, had the June contract fallen five points to 98.70 while the September contract fell 10 to 98.40, the spread would have also widened to 0.30 (98.70 — 98.40). In either scenario, a trader long the spread would be slightly ahead on the position.
Don’t let the complexity of spread trading distract you from participating in the strategy. Futures spreads can be a great way for risk-averse traders to expose themselves to the commodity markets with the hopes of reduced levels of volatility.