The world of trading is rife with many approaches and techniques to potentially turn a profit. Although it is one of the most effective tactics, arbitrage trading is also one of the most difficult. As an arbitrage strategy, futures spread trading is preferred by many traders. They view it as one of the more secure approaches to trying to make money off the commodities market. We’ll help you learn more about the most common futures spread trading methods and how to use them in this article. We will also look at some futures spread trading instances and their benefits and drawbacks.
Explaining a Futures Spread
The concept behind futures spread trading strategies is risk reduction. It also allows you to benefit from pricing inefficiencies in one or more instruments. In other words, you can take advantage of a price differential by opening both a long and a short position at the same time by using a futures spread. Spreads are useful for a variety of asset classes. In this essay, we will specifically use it with futures trading and commodities.
Because of the nature of the market, spread trading strategies were previously limited to institutional and large-scale traders. Retailers, however, are beginning to take a liking to them these days. This is the outcome of both lowering margin requirements and technological developments.
How Do Futures Spreads Work
The goal of trading techniques for futures spreads is to capture the difference between the price of the contract being bought and sold. This usually works when trading futures with different expiration dates.
A futures spread occurs when you trade for instance a soybean futures contract (ZS) by going long and short at the same time. It can also be applied to different types of assets, such as soybeans and corn.
When a trader opens both buy and sell positions at the same time, they are called “unit trades” and are treated as a single position. The terms “legs” relate to the unit deal’s buy and sell sides. In this manner, the difference in positions ensures they make a larger profit.
Types of Futures Spreads
Depending on the commodity type, its current state, and the specific trading strategy, a futures trader has a choice of three types of futures spreads, commodity product, intra-commodity, and inter-commodity spreads.
In addition to this, experts also talk about an uncommon type which are bull and bear futures spreads. The difference between the two is that a trader who trades bull futures spreads shorts the delayed month and buys the front month. Meanwhile, he shorts bear futures spreads on the front month and goes long on the deferred month.
Now let’s go back to the basic types.
Inter-Commodity Futures Spreads
An inter-commodity futures spread uses contracts on various commodities for the same month. Like when buying September-expiring wheat futures (ZW) and selling September-expiring maize futures (ZC) at the same time.
Whoever is interested in inter-commodity futures spreads must comprehend the features and the variables affecting the price of the products they intend to trade. This means that you must be knowledgeable in trading a wide range of futures contracts, which is usually not the case for those who are new to the market.
Intra-Commodity Futures Spreads
Intra-commodity futures spread trading is the practice of purchasing and selling the same commodity in different months. For example, the trader may buy a contract for soybean futures in April and sell one in October. In this case, the “legs” of the trading spread are between different months rather than other instruments.
These types of futures spreads are sometimes known as “calendar spreads”.
Calendar spreads are supposed to be easier to trade because the trader only needs to specialize in one commodity. By gaining an in-depth understanding of a variety of factors that influence prices, like supply and demand, weather patterns, seasonality, etc, they can ensure that they have the necessary abilities to handle that particular asset.
Commodity Product Spreads
Commodity product spreads represent the price difference between the commodity as a completed good and in its raw form.
Spreads on commodities are a popular choice among traders who have an interest in the oil and agricultural industries. Traders usually love this type of commodity product spread, which they take advantage of by shorting the related completed product and going long on the raw material. This way, the profit basically reflects the profit margin of the company running the whole operation.
Keep in mind that this type of futures spread is frequently a more complex financial instrument.
Futures Spread Margin
Any trader in the futures market who is interested in futures spread trading has to understand margin requirements. They show the degree of risk and volatility connected to the underlying commodity or, if many assets are traded, the relationship between them.
Because futures contracts are less volatile and provide a systemic risk hedge, their spread margins are lower than those of typical futures contracts. Both legs of the unit trade should be equally impacted in the event of an unforeseen catastrophe, such as a terrorist attack, a stock market collapse, the start of a war, or a nation’s debt. The trader won’t suffer any losses in this manner.
Illustration
Let’s say a trader wishes to trade futures spreads on corn and wheat. Assume that the margin on corn futures is $2,000 and the margin on wheat futures is $1,000 at the moment. Joe can get a 75% margin credit rather than posting $3,000 to trade the spread on the two contracts. This implies that the starting margin will only be $750.
This illustrates the stark contrast between trading single contracts outright and trading them as a spread in terms of the required margin. The futures spread margin can frequently be as little as 10% of the total amount of the margin required for a single contract, depending on the product.
It’s crucial to check with your brokerage before trading.
A Closer Look at Specific Assets
When it comes to natural gas or crude oil, traders mostly rely on the seasonality effect in their analysis. For instance, the requirement for energy and heating rises throughout the winter, increasing the demand for natural gas.
Conversely, as traffic grows throughout the summer, so does the demand for petroleum. The result is an increase in the price of crude oil.
With crops, it is the same situation. Traders may change their preferences for specific commodities based on a variety of circumstances, including the harvesting season, weather, supply and demand statistics, farmer preference for one seed over another, and other similar considerations.
Ultimately, regardless of the spread you are trading, remember to focus more on the relationship between the spread’s two legs than the market’s general direction. In downward markets as well, you will profit if the spread is favorable enough.
How to Trade Spreads in Futures
While trading futures spreads is less hazardous than buying and selling individual futures contracts, it still demands a high level of skill and focus. For instance, while trading inter-commodity futures spreads, the trader needs to be knowledgeable about the characteristics of several contracts.
Learning the key elements and traits of the many commodities or instruments you are willing to trade is the first step towards being a profitable futures spreads trader. These are a few of those elements:
Time of Year
First and foremost, take the season into account. It is important that you understand how it could impact the cost of the instruments you are willing to exchange. One of the things that hurts the price of the instruments is the season. Whether you are trading futures spreads or buying or selling individual futures contracts, there is a genuine risk involved.
The rationale is that supply and demand are determined by seasonality. Certain commodities—like natural gas, for instance—might see increased demand in the winter, while others—like crude oil—might see more demand in the summer. Conversely, a mild winter may lessen the need for gas and heating oil, which would lower their cost.
When it comes to trading grain futures, where the prices are determined by the outcomes of the harvest season, the situation is comparable. These are also directly impacted by the weather. Using corn as an example, we may state that it is most abundant in the fall, which could lead to a drop in price at that time of year. Since grains are most susceptible to harsh weather in the late spring and early summer, this is typically when their prices peak. For this reason, you should anticipate that the price of the grains will be impacted by a so-called “weather premium,” which varies based on the year and weather predictions.
The easiest way to overcome the seasonality effect is to analyze the spreads’ performance over the years and see over which time periods they perform the best.
The Political Situation and Macroeconomic Conditions
It’s critical to pay attention to the macro issues that could impact your spreads in addition to the particulars of the commodity. Trade wars, embargoes, international political unrest, interest rate policy, financial and economic crises, regional advancements, etc. are a few examples of these.
All kinds of futures spreads depend on this, but inter-commodity and product spreads require it the most. Although there would be some variation in the case of intra-commodity spreads, both legs of the trade should be similarly affected overall. For instance, if you trade crude oil in April and August and there is unrest in the Middle East, the difference between the buy and sell orders should not change.
Stay Informed About the Industries
Commodity and futures trading markets are extremely volatile. Every day brings new developments, therefore, to be successful as a futures trader, you must stay up to date on the latest information on the sectors that interest you.
The best method to accomplish that is to have an official industry study or report with your morning coffee. Depending on the futures spread contracts you are interested in trading, these are good places to start:
For interest rate bulletins, financial futures spreads, and any relevant government economic news.
The official reports from the US Department of Agriculture in the case of cattle futures spreads.
Specifically for grains such as maize, the U.S. Grains Council reports, the WASDE Report, the Planting Intentions Report, the Crop Production Report, and the Grain Stocks Report from the National Agricultural Statistics Services (NASS). Additionally, you can monitor the Global Drought Monitor.
The weekly statistical analysis from the American Petroleum Institute and the weekly data from the Energy Information Administration on crude oil futures spreads.
You get the point, of course; there are many more sources. Keep up with the latest developments to boost your chances of making money.
Strategies For Trading Futures Spreads
You can employ a range of trading tactics for futures spreads. We’ll go over a few of the most common and fundamental ones here. We’ll discover practical applications for them as well. Recall not to merely adopt these tactics at face value. When you try them, use your own discretion.
Gold Bull Spread
Using this intra-market spreads approach, you must purchase and sell the same contract with separate expiration months. To profit from temporary price spikes is the aim here.
Here’s how this functions in real life. Assume for the moment that you are interested in using a spread technique to trade soybean futures (ZS). You can do that by:
- First, purchase soybean futures (ZS) for November 2020 at a price of $874.4.
- You ought to sell one ZS futures contract at the same time. Assume for the moment that you are asking $885.0 for March 2021 ZS.
- You read reports and keep up with the news in the interim to be informed about the variables that could influence the commodity’s price.
- You will make money if the front month’s contract price increases more quickly than the deferred month’s contract price.
The spread narrowing is the ultimate objective here. This occurs when you short the longer-term contracts and go long the nearer-term ones during bull markets because the latter are slower to respond to price fluctuations.
Gold Bear Spread
Naturally, the above-mentioned strategy’s bear-market variant operates in the opposite manner. In bad markets, you should anticipate that the price of the nearer month contract will decline more quickly and significantly than the price of the deferred one. The goal of this approach is to profit from expanding spreads.
Pros and Cons of Trading Futures Spreads
Futures spread trading may appear to be the safest trading method ever at first glance. In actuality, though, there are a few disadvantages in addition to its many benefits. In instance, the list of the former might be rather lengthy. We will discuss each in detail, concentrating on the primary benefits and drawbacks of trading futures spreads:
Trading Futures Spreads Benefits
- Superior Risk/Reward Compared to Trading Individual Futures Contracts:
Futures spreads not only drastically lower risk but also offer multiple avenues for profit-making. Futures spreads are regarded as a far more balanced instrument than single contracts, while being regulated and having less leverage than single contracts.
- Predictable Price Movements:
The trading of futures spreads facilitates the prediction of the various contracts’ responses to specific occurrences. The price of the closer contract is typically more impacted than the longer-term contract’s price during both down and bull markets.
- Reduced Need for Margin:
Over time, there has been a significant reduction in the margin requirements due to the lower risk associated with trading futures spreads. In comparison to trading individual futures contracts, the trader receives a far higher return this manner.
- Clients with Small Portfolios Are Welcome:
A typical stock or futures broker may require you to deposit $5,000 or more to be eligible to trade. With futures spreads, however, things are quite different. Depending on the service provider’s requirements, often you can open an account with just $50.
- A Good Field for Beginners to Make their First Steps:
Futures spread trading eliminates systemic risk, which is the most unpredictable and problematic event for beginners and professional traders. This makes them a much better place for newbies to make their first steps, without the fear of losing significant capital.
Trading Futures Spread Drawbacks
- Commissions Increase with More Trades:
The primary disadvantage of trading futures spreads is that every trade has two legs: the purchase and sale of an instrument. This effectively doubles the trading commissions. They could devour a sizable portion of your earnings if you do not consider them at the outset while developing your approach.
- Possibly not Enough Liquid:
Spreads on futures are frequently less liquid than trading individual futures contracts or other securities. This could be a challenge for traders who need to quickly enter and exit positions.
- Risks Involved in Trading Futures Spreads:
The primary risk in this kind of trading, as in any other, is taking on unreasonably big positions. You should not, however, take it lightly. Traders risk losing a significant portion of their money if they don’t follow certain fundamental risk management guidelines. Particularly if they are incorrect in their spread prediction.
Another risk is becoming trapped in a trade because there isn’t enough liquidity. You can find it difficult to exit your position because futures spreads have a comparatively lower trading volume. particularly when combined with circumstances in which dealers purchase and sell increasingly exotic futures. If you fall into that trap, your profit could drop significantly.
