Spread Trading: Gauging Market Relationships
BY SCOTT BARRIE AND LAN TURNER
©2003, Reprinted with permission of Active Trader magazine (www.activetradermag.com)
Spread trading in the futures market is similar to “pairs trading” in the stock market. “Spread” refers to the price differential between different futures contracts. A spread trade is the simultaneous purchase and sale of two or more futures contracts with the goal of profiting from the increase or decrease of the spread rather than the increase or decrease of the individual futures contracts.
Examples of spreading include: buying one futures contract month and selling another futures contract month of the same market; buying and selling the same market and delivery month, but on different exchanges; buying or selling a certain delivery month in one futures market and taking the opposite position in the same (or nearly the same) delivery month in a different, but related, futures market.
Although some futures spreads have a directional bias, the absolute price levels of the underlying futures contracts are not important; the only thing that matters is the relative performance of one contract vs. the other. In other words, a spread trade is a speculation that one contract will outperform another contract. Both contracts can move in the same direction and the spread trade can still produce a profit.
Commodity spreads, such as grain futures spreads, expand and contract based on good or poor conditions during planting, growing and the harvesting periods, both for domestic and international production, as well as differences between supplies in storage and future production. When the conditions become extreme, known as weather markets, the intraday volatility in the underlying contracts can climb dramatically, and spreads provide a sound approach to trading. Some spreads have advantages in terms of margin requirements and relative volatility that, in certain situations, make them attractive alternatives to outright futures positions.
Finally, many spreads are tracked using a seasonal and historical perspective. Traders look for similar conditions and can gauge what may occur in the price of a spread based on conditions. For example, each time the Fed changes policy from rising to lowering interest rates, traders look at the movement of
the NOB spread (for T-notes over T-bonds) in the past to estimate where the spread could go.
The three basic spread types
There are three basic types of spreads: intramarket, intercommodity and intermarket.
An intramarket spread — also known as an intermonth or delivery spread — is the most common type of spread. Intramarket spreads are the simultaneous purchase of one delivery month and the sale of another delivery month in the same futures market on the same exchange. An example would be buying July soybeans and selling November soybeans on the Chicago Board of Trade (CBOT). An intramarket spread is designed to take advantage of the price differential between two delivery
months in a futures market when the trader perceives the difference is abnormal.
Intercommodity spreads are the simultaneous purchase of one futures market delivery month and the sale of a different but related futures market with the same (or similar) delivery month. Some examples of intercommodity spreads are long August lean hogs and short August live cattle (meat contracts), long March Nasdaq futures and short March S&P futures (stock index contracts), and long 30-year T-Bonds and short 10-year T-Notes (interest rate contracts).
The stock-market equivalent of the intercommodity spread is the “pair trade” — for example, long Dell Computer (DELL) and short Gateway Computers (GTW). Although this type of spread trade can theoretically include any combination of two futures contracts, only a few of the combinations are “exchange recognized” spread trades that are margined at a lower rate than the individual contract rate, which is one of the benefits of spread trades.
Intermarket (interexchange) spreads consist of buying a futures contract on one exchange while selling the same contract and delivery month on a different exchange — for example, buying March wheat on the CBOT and selling March wheat on the Kansas City Board of Trade (KCBOT).
For many years, the interexchange spread has pretty much been limited to the wheat market, trading either CBOT wheat vs. KCBOT wheat or Minneapolis Grain Exchange (MGE) wheat, or KCBOT wheat vs. MGE wheat. In the past, there was a wider range of opportunities, including trading Chicago metals vs. New York metals, but these opportunities dried up over the years. (However, the advent of single stock futures raises the possibility of intermarket spread trading opportunities between contracts traded on the OneChicago and Nasdaq- LIFFE exchanges.)
Regardless of the type of spread, the logic behind all of them is that the long side of the spread will increase in value relative to the short side of the spread (or, it will decrease in value less than the short side).
For example, if both the long and short sides increase in value, the spread position will profit (before commissions and fees, of course) if the long position increases more than the short position. If, on the other hand, both positions decrease in value, the spread trader can still garner a profit if the long position decreases in value less than the short position.
In other words, the overall market direction does not matter in a spread position; only the rate at which the contracts move — that is, the relative pricing — between the two contracts counts.
Calculating and quoting spreads
Spread prices are typically quoted as the price differential between the two markets that make up the position. The actual prices of the individual contracts do not matter.
Spread price = long position price – short position price
Spread positions are generally described as “long/short” — i.e., the contract being purchased is stated first and the contract being shorted stated second. For example, assume you are considering the following spread: buying August 2003 live cattle (LCQ03) and selling June 2003 live cattle (LCM03).
This spread would be referred to as an “August/June” live cattle spread.
Spread quotes can be either positive or negative. If the sell side (short) of the spread is higher than the buy side (long), the resulting spread price will be negative. Many brokers and floor traders refer to this as a “discount.” For example, if the August live cattle contract is trading at 66.15 and the June live cattle contract is trading at 68.125, the spread would be quoted at a price differential of -1.975 —
a discount of 1.975.
If the buy side is trading above the sell side, the spread is generally quoted as a “premium.” For example, if you were considering the June/August live cattle spread — buying June live cattle and selling August live cattle –— you would say you are buying June live cattle at a premium of 1.975 to the August. (When placing an order, this would typically be shortened to “buy June, sell August at 1.975, premium buy side.”)
Why spreads fluctuate
Different contract months in the same market, or different markets, can diverge from their typical price relationships (thus increasing or decreasing the spread) for various reasons.
For example, the marketing year for soybeans runs from September through August of the following year. As a result, the July futures contract represents “old crop” soybeans (that is, those from last year’s harvest) while the November futures represent “new crop” soybeans (yet-to-be-harvested soybeans).
The difference, or spread, between the prices of these two contract months can shift dramatically, as it did in 2002 when July soybeans gained more than 60 cents per bushel relative to the November contract because of imminent drought fears.
Some popular intercommodity spreads, such as the live cattle vs. lean hog spread, can shift when
the two markets, which usually move in similar directions, diverge because of circumstances unique to one or both markets. For example, in January 2003, cattle prices rose while hog prices fell, resulting in greater price volatility in the spread than in the outright futures positions of either market.
Similar examples are apparent in popular financial market spreads, such as the S&P 500 vs. Nasdaq 100 spread, when the market favors one area of the market over another, and these indices diverge.
The advantages and disadvantages of spreads
Buying and selling spreads is a different kind of speculation than the short-term, hit-and-run trading most futures traders engage in. The three main reasons most often given for trading spreads rather than the outright contracts are lower risk, lower margin rates and increased predictability.
Because spreads involve both a long and a short position in related markets or contracts, they are, in effect, partially hedged positions. As a result, a well-chosen spread can have lower volatility and risk than an outright futures position. However, there are certain spreads that can carry magnified risk — including certain intramarket spreads, such as “old crop” vs. “new crop” spreads, and intermarket spreads.
Because of the partially hedged nature of many spreads and their reduced risk, spreads usually have lower margin requirements than outright positions. For example, in late March, initial margin for live cattle was $810 per contract, while the margin for the August/June live cattle spread was only half that — $405. Lower margin requirements mean you tie up less money in a position and can participate in certain markets with less risk.
Another advantage of spreads is they are slightly off the beaten path. As a result, profit opportunities in this area have not been traded out of existence through excessive market competition. Also, spreads (especially intracommodity spreads) are generally less volatile than outright futures positions, making approaches such as trend following easier to implement.
The other side of the coin
Risk and reward are almost always directly proportional in the world of speculation. The lower risk of many spread trades (especially intracommodity spreads) means potential rewards are smaller as well.
Another drawback of trading spreads is double commissions. Spreads involve two different futures contracts, and both sides are assessed commissions and exchange fees. Commissions in the futures market are generally charged on a per contract basis, and therefore trading a spread involves twice the cost of trading outright futures positions.
An alternative — for some traders
Spreads are an often-overlooked alternative to outright futures positions in the trading arena. The speculation that one contract will outperform another is generally less volatile than outright futures positions. Thus, traders looking for generally lower risk and lower volatility may find this an attractive way to speculate in the futures markets.