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.
SPREAD, SCENARIOS, AND STRATEGIES
My broker seems to use the term “spread” to describe several scenarios and strategies, and sometimes it can be difficult to follow. Can you explain the different uses and definitions?
Those unfamiliar with futures market slang can be misled by the use of some commonly used terms in the world of commodities. Early on, I too found myself confused. Accordingly, I devoted an entire chapter in my latest book, A Trader’s First Book On Commodities, to deciphering futures market slang.
“Spread” is used loosely among futures traders but is primarily associated with three different situations. It is up to the listener to identify what is being discussed. Before we examine each use, let’s remind ourselves that the definition of spread in its simplest form is difference.
•Bid/Ask Spread
Any asset, whether it be futures, options, or baseball cards (from a dealer) has two prices: one that you can buy and one that you can sell. Unfortunately for us, retail traders pay the higher price to buy and must sell at the lower price. The difference between these two prices typically goes to the middleman and is referred to as the bid/ask spread, or simply the spread.
In conversation, brokers and traders refer to the bid/ask as the spread. Any time that you converse about the price of a commodity option or futures contract and someone mentions the spread, they are referring to the difference in the prices in which it can be bought or sold. It is more likely that the spread will be mentioned in option trading than in futures; most liquid futures contracts have a spread of one tick, but options can be more substantial depending on the market.
•Option Spread
Similar to the bid/ask spread, you will rarely hear a broker or trader refer to an option spread as such; usually, it is shortened to a “spread.” An option spread is most commonly a position in which long and short options are combined with a common goal but with less risk than trading the options outright. However, an option spread might be two long or two short options, as in strangles or straddles. In essence, a spread that involves long and short options will typically see profits in one or more components of the spread and losses on the remaining. The trader’s overall gain or loss is determined by the difference between the two — in other words, the net. Hopefully, the profitable options are making more than the losing options are underwater.
The most common spreads, but not the most ideal, are the bull-call and the bear-put. A bull call spread involves the purchase of a near-the-money-call and the sale of an out-of-the-money call. If you ever hear traders talk about a “call spread,” this is what they are referring to. Likewise, a “put” spread is the purchase of a near-the-money put and sale of an out-of-the-money put.
Where many get confused is that each spread (option spread) has a spread (bid/ask spread). So a 1180/1230 call spread in the March S&P (a trader buying the 1180 call and selling the 1230 call) might face a price of 10.20 bid and 11.00 ask. Many traders and brokers try to cut the confusion by differentiating the spreads. In this context, the bid and ask spread is no longer identified as a spread; instead, it is the bid/ask. Similarly, the option spread reverts to the specific name of the spread, whether it is bull-call, bear-put, butterfly, and so forth.
•Futures Spread
Based on my time as a broker, I have found that traders are more comfortable trading option spreads as opposed to futures spreads. Nonetheless, it is something that you will run into from time to time. Things will be much less complicated if you can recognize when your broker, or your buddy at a cocktail party, is talking about a futures spread and when the conversation might be regarding an option spread.
A futures spread is much less diverse than an option spread, which entails a nearly unlimited number of possibilities. A futures spread most often involves the purchase of one futures contract and the sale of another in a correlated market or alternative contract month. Unlike an option spread, futures spreads are almost always referred to in conjunction with its components. For instance, a July/December corn futures spread would be identified as such and involves the purchase of July corn against the sale of December corn, or vice versa.
Similar to an option spread and any other traded asset, a futures spread has both a bid and ask price. If you intend to trade futures spreads, keep in mind that it is often better to trade them via open outcry execution as opposed to the electronic market if you are going to name a price (limit order). On the other hand, if you are less worried about price and more worried about getting filled, it is best to execute each futures contract individually. Don’t worry, you will receive spread margin regardless of how you executed the trade.
These simple rules might seem obvious to some, but for those who aren’t familiar with them, a simple misunderstanding can mean disaster. Good luck!