seasonal futures spreads

This post originally appeared in FutureSource’s Fast Break Newsletter on June 23, 2010, where Craig Turner is a regular contributor on various futures trading topics.

Why We Trade Futures Spreads

When it comes to Futures Spreads, many traders ask us what is the benefit of spreading futures contracts. They want to know why we often choose to spread futures contracts instead of either being long or short a single futures contract or option, or use option spreads instead. In our experience, futures spreads, also known as pairs trading, offers the leverage of futures contracts, helps hedge systemic risk, eliminates stops, and we get this reduced risk without having to pay up for time premium as options traders do. When you factor in opportunity available, risk management, cost effectiveness and margin efficiency, Futures Spread Trading can be a far superior strategy over flat priced futures trading, options and option spreads.

Futures Spreads Defined

Futures Spread Trading is a strategy of simultaneously buying a particular contract and selling a related contract against it. This strategy is also called pairs trading. In pairs trading, one market within a sector is bought and a separate market in the same sector is simultaneously sold short. This provides an investor with exposure to the relative performance of the two commodities with limited exposure to broader market and sector performance.

For example, let’s say you think the US is in the midst of a very strong and robust recovery and growth period (I know – it is very wishful thinking). If that is true, then small cap equities will outperform large cap equities. Smaller companies can grow much faster than larger ones in percentage terms. A futures spread trader would see this as an opportunity to buy the Mini Russell 2000 and sell the Emini S&P 500. The Russell 2000 is a small cap index and the S&P 500 is a large cap index. In times of economic recovery and growth, small caps should outperform large caps. In times of economic recession large caps should outperform small caps.

Benefits of Spread Trading

Trading spreads limits the exposure to systemic risk. In other words, it minimizes the risk associated with outside factors that can affect commodity prices.

Let’s take an example. Dec Corn is trading higher at $4.00 while July Corn is around $3.50. After studying the fundamentals and/or charts, you feel Dec Corn should drop 25 to 50 cents while July Corn will remain unchanged.

You short Dec Corn. The next day the Fed announces it is bailing out Europe. Money floods the US and International financial system. The US Dollar Index plummets, and over the next month the USD decline sends Dec Corn higher to $5.00, July Corn higher to $4.50.

If you had been short Dec Corn and long July Corn the spread would still be around 50 cents and you have time for Dec Corn/July Corn to narrow, which it certainly may do. If you were only short December Corn you lost $1.

You may have been fundamentally correct, that Dec Corn was overvalued and should be sold. But since you did not long the July Corn, you lost money even though you were correct about the market fundamentals. The change in the value of the US Dollar turned the trade into a loser.

We use pairs to eliminate as much systemic risk as possible. We want our trading to be about the relative value of two commodities or crops within the same market. We want to minimize the effect of outside market forces as much as possible.

How Spreads Make (and lose) Money

There are two types of spreads. The first is intra-commodity spreads, also known as calendar spreads, which are in the same commodity. Intra-commodity spreads are all about the near month vs. the deferred month. A bull futures spread is when the trader buys the near month and sells the deferred month. This is a bull spread because in a bull market the near months will move up faster than the deferred months. For example, if Crude Oil is in a bull market, the price of the nearby futures contract will increase faster than the price of crude 6 moths out, and even more than the contract 1 year in the future.

On the opposite side of that is the bear futures spread. That is when the trader sells the near month and buys the deferred month. In a bear market, the near months will move down faster than the deferred months. In the futures markets, the near months have the most volume and open interest, so those months are the ones that are going to make the biggest price moves. The near months almost always move faster and farther in both bull markets and bear markets when compared to the deferred, less traded contracts.

The only times when the contracts tend to move up and down at the same time, is during market panics and major sell offs. In those situations investors and traders tend to “shoot first, interrogate second,” as the good gets sold with the bad. During the sell off it is most likely the nearby and deferred are being sold equally.

The second type of spread is an Inter-Commodity Spread. This is a spread between two different markets, like Corn Vs Wheat or Heating Oil vs. RBOB Gasoline. Let’s say we think farmers are going to plant more Corn than Wheat. That would be bearish for Corn prices and bullish for Wheat prices. We would short Corn and get long Wheat. It doesn’t matter if Corn and Wheat go up or down in value. All that matters is that Wheat holds up better than Corn. If the markets rally, we want to see Wheat gain more than Corn. If the markets decline, we want to see Corn go down more than Wheat.

Hedging Systemic Risk

We trade futures spreads to hedge against systemic risk. You never know when the next shock to the system or market crash will happen. We’ve learned through out the years to never expose ourselves to more risk than necessary.

When a trader in long one contract and short another, they are hedging out the USD. The USD represents the entire US economy. If we can hedge this out of our positions, we do so immediately. Let’s say we are long the Crude Oil (CL). That means we are long CL but we had to put up cash margin to get that position. The CL contract is priced in USD. In that case, we are not just long the CL, we are also short the USD. If we used USD to get long CL, we have a long CL/short USD position, or a CL/USD cross. If Greece defaults on their bonds, sending the Euro into a tailspin, the USD will go up materially. The rising USD puts pressure on Crude Oil, sending CL down.

The only way to offset this risk is to spread Crude Oil against a deferred contract or another market. Let’s say July Crude is the front month. We are bullish Crude Oil and we buy July. To cancel out the USD we sell December Crude, creating a long July Crude, short Dec Crude spread.

Why do we do this? If we are long July Crude, we are really long July Crude(CLN) and short USD, or CLN/USD. If we short December Crude (CLZ), we are really short December Crude and long USD, or USD/CLZ. When you combine the CLN/USD and USD/CLZ, you get a CLN/CLZ cross. The long USD and short USD cancel out.

If some catastrophic even happens on the other side of the world, causing the USD to rally and CL to decline, my spread should be intact. Whatever amount July Crude decreases, most likely Dec Crude will go down to. The outside event will have been properly hedged.

Leverage and Margin

Futures Spreads should reduce your margin, but more importantly, it will reduce the leverage you are using. When you are long the Emini S&P 500 overnight, you have overnight margin of $5625. When you are short the Emini DJIA, you have overnight margin of $6500. However, if you are long the ES and short the YM, the margin is not a combined $12,125. There is a spread margin credit and the total overnight margin is reduced to $2054. That is about a 83% reduction.

Why are margins reduced? Futures spreads are generally less volatile than being just long or short a single contract. The exchanges understand this and reduce the margin requirements. Futures spreads are generally less volatile because they narrow down the trading ideas and factors involved in the trade.

When you are long the Emini S&P 500, you are not just long the S&P index. You also have exposure to the USD and the US financial system as a whole. This is massive exposure to events and conditions that are impossible to predict or account for. When you spread a contract, you are hedging out the USD, or outside market forces, and just making the trade about two very specific markets. There will be fewer factors and therefore fewer unknowns by hedging out the USD. This is another reason why the margins are reduced.

The leverage traders are using in their accounts are also greatly reduced, which is a good thing. Most traders over leverage their accounts. Overleveraged accounts either lead to traders blowing out their accounts on a big market move against them or slowly bleeding the account to $0 because they use stops that are too close to the normal trading range.

Stops

Futures spreads do not have stops. They are not accepted at the exchange. Good news is you really don’t need them if you are properly leveraged. It is one of our favorite aspects of futures spread trading. I can’t stand it when an event half way across the globe sends the market down (or up) and it triggers a stop in one of my positions. I may be correct about the bullishness of Gold or Crude Oil, but a 5% decline in the Japanese Stock Market stops me out overnight, and then Gold or Crude goes up again.

The nice thing about futures spreads is they typically eliminate the outside market risks if the spreads are thought out and executed properly. In our experience, traders tend to put their stops within normal trading ranges. This makes the trader need to be exactly right in direction and timing for a trade, or they will be stopped out. Why do traders do this? Because they only want to risk X amount of money in a trade. If X amount of money is smaller than the daily trading range Y, then traders are too leveraged for the positions in their accounts.

Either the traders need to use more capital per trade, or they can reduce their margin, leverage and risk by using futures spreads. If traders want to take a bullish position in the market, they can buy the front month and sell a deferred month. If they want to take a short position in the market, they can sell the front month and buy the deferred market.

Markets to Spread

Any market can be spread traded. Some markets like the grains, livestock, energies, softs and financials are more common than the indices, currencies and metals. All markets can have calendar spreads or inter-commodity spreads. However, all markets might not have a spread discount. Spreading Corn vs. Wheat gets a 60% reductions in margin because they are related markets. Spreading Coffee vs. Cocoa has no margin reduction because the fundamentals of the two markets have nothing in common. If the markets are related fundamentally, there is a good chance a spread credit exists. To find out if markets have spread credits just go to the Margin/Performance Bond section of the Exchange web site.

Historical Seasonality

Many spread traders follow seasonal trends and patterns. Many futures markets have seasonal patterns. Crude Oil and RBOB Gasoline tend to increase during the summer while Heating Oil and Natural Gas tend to increase during the winter. The Grain markets are seasonally the highest in the spring and summer months and lowest right after harvest in the late fall.

Traders follow these patterns and trade the seasonal channels. For example, this time of year the grain markets tend to go up faster in the old crop vs. the new crop. Traders will buy July corn and sell Dec Corn, or buy July Soybeans and sell Nov Soybeans. Any shortage in beans or concerns about the crops will cause the near months to rally faster than the deferred months. This seems to happen more often than not, which makes it a very popular spread trade.

Summary

Traders looking for ways to reduce risk in futures positions should seriously consider spreads. In times like these, no one knows when the next Greece is going to happen. Futures spreads can help protect your risk against outside market events. Futures spreads can reduce leverage and allow traders to take positions without the need for tight stops that will most likely just stop them out. Futures spreads allows traders to take advantage of medium to long term moves with less capital.

Spread Trading Ideas

Natural Gas

Natural Gas has broken out to the upside since the BP Gulf Oil spill. Many traders think just getting long Natural Gas is too risky because Natural Gas can be a very volatile futures contact. Entering a Bull Futures Spread in Natural Gas gives the trader exposure to Natural Gas but cuts down on the volatility of just being long a single contract. The trader also does not have to worry about losing time premium like he would with a call option or bull call spread. Here is an example of how a trader would get long Natural Gas with a Bull Futures Spread.

Buy August Natural Gas and Sell December Natural Gas at -0.600 or better. Risk to a close below -0.700 ($1000). Target is -0.4000 ($2000). Initial Margin is $1688 and Maintenance Margin is $1250 per spread.

Natural Gas Chart

Click to View Larger Natural Gas Chart

Corn

Corn looks to have bottomed and seasonally this is the time of year when Corn has its best chances for higher prices. Corn prices can be volatile this time of year, especially due to changes in weather and USDA reports. Traders looking to take a bullish position in Corn but cut down on the volatility can buy September Corn and sell December Corn, which is a Futures Bull Spread.

Buy September Corn and Sell December Corn at -10.50 cents or better. Risk to a close below -12.50 ($100 risk). Look for a rally in old crop Corn to send the spread to -5.00 (+$275) and a very bullish market to bring the contracts to even (+$550). Initial Margin is $270 and Maintenance Margin is $200 per spread.

Corn Chart

Click to View Larger Corn Chart

Sugar

Sugar made historic highs earlier this year. Now that the new crop of Sugar is coming in, many analysts feel Sugar will be heading back down to 12 or 13 cents a pound. There will be price spikes in Sugar as commercial users still need to buy Sugar until the new crop is delivered to the market. To cut down on the volatility, traders can sell October 2010 Sugar and Buy March 2011 Sugar, which is a Bear Futures Spread.

Sell October 2010 Sugar and Buy March 2011 Sugar at -0.70. Risk to a close above -0.50 ($244 risk). First target is -1.14 (+$492.80). Initial Margin is $840 and Maintenance is $600.

Sugar Chart

Click to View Larger Sugar Chart

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Spreads Risk Disclosure: A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts. It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread). In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Seasonal futures spread trading is one of the best futures trading strategies that most futures traders have never heard of or just don’t know much about. Sometimes people see “spread trading” and automatically think about options or currency trading. Seasonal futures spread trading has nothing to do with options or spot Forex, and if you’ve found this article looking of options strategies, you’ve come to the wrong place. However, if you are interested in a classic, time tested trading style that is used routinely by commercial and professional traders, this is the place to be.

What is a Futures Spread?

Futures spread trading is when a trader is long one futures contract and simultaneously shorts another. This is also known as pairs trading. Again, we are talking about futures contracts, not options. When traders spread futures contracts, they are only interested in the change in the relative value between the two contracts. The beauty of this concept is the position has limited exposure to external market forces like Fed Interest Rate announcements, stock market crashes, international incidents or natural disasters. If you are tired of being stopped out of a position because of an unrelated event occurs half way around the world, you’ve found your solution. In other words, futures spreads helps reduce systematic risk, which you can learn more about here: Hedging Systematic Risk. This allows the trader to implement a trading strategy and not have to worry about a market crash because some small European country is going to default on their debt, which had nothing to do with the trade or investment in the first place.

Spread Trading Example

For example, let’s say it is 2007 and you are long Goldman Sachs stock. You are unsure of the state of the financial system. However, you think Goldman is the best bank on The Street. You also think that Bear Stearns is the worst bank on Wall Street. You can be long Goldman, but if the banking system collapses, it does not matter that Goldman is the best bank in town, the common stock price will decline with the rest of the market. You could also just short Bear Stearns, but if the financial system stabilizes and the economy improves, you will lose as Bear goes up with the rest of the market.

Suddenly, you have an epiphany! If you are long Goldman Sachs and short Bear Stearns, it should not matter if the market crashes or has a great bull run. If business conditions are poor, Goldman should fair better since it has a stronger business. If business conditions are favorable, you expect Goldman to get more of the business opportunities than Bear. Regardless if the market goes up or down, the price of Goldman should outperform the price of Bear. It does not matter what the outside markets are doing, it all just depends on the performance between Goldman and Bear. Your trading possibilities just became endless.

(Full Disclosure – I was employed by Goldman Sachs from 2000 to 2007 and regularly used this spread trade strategy when employees were in a lock-out period for Goldman stock when we reported quarterly earnings)

The problem with pairs trading in stocks (pairs trading is another name for spread trading) is that stock is not easy to short, you have to pay interest on the shares you borrow, and if you are short stock during a dividend, you have to pay the dividend out of you own pocket to the investor you originally sold the shares to. It gets very complicated if you are not completely on top of how shorting stock works, it can do you more harm than good.

The Solution is Futures Spreads

Luckily, shorting futures contracts carries none of the mentioned complications that occur when shorting stock. It is just as easy being long a futures contract as it is being short a futures contract, you don’t pay interest on the short position in futures like you do in the equity markets, and there are no dividends you need to pay or worry about in commodity futures. Spread trading in futures is much easier to execute and more efficient with capital and trading costs.

Professional traders know this, and that is why so many of them spread trade futures contracts. There are many philosophies and methods for futures spreads, but if you are new to futures spreads and want to seriously try to learn about them, then the first thing you need to study is seasonal spreads. Seasonal futures spreads are some of the most effective trading spreads strategies you will find, they are easier to understand, and it will create the base of knowledge to explore other kinds of futures spread trading.

Seasonal patterns occur frequently in the commodity and futures markets. Grains tend to trade highest in the late spring and early summer because that is when the crops in the ground are the most vulnerable to weather conditions. Is this always the case? No, there could be years when there is no weather or growing issues and prices could decrease. However, many years there are weather or growing concerns and it can build weather premium into the crop prices. While the market generally prices in these weather premiums each year, there is still room for these expectation to come to fruition because the weather and crop conditions will either be better or worse than was originally expected, and that is where the opportunity lies. Most commodities experience a natural cycle of supply and demand during the year, which can lead to natural cycles in higher and lower prices because of the seasonality of supply and demand.

Seasonal Futures Spread Example

For our seasonal example, let’s look at the Lean Hogs market. Lean Hogs production typically peaks in early December, a few weeks before the holidays, and then has a seasonal decline until the spring when pork demand rises again for the summer cookout season.

To take advantage of this seasonal trend, we would sell February Hogs, which is the front month for when the seasonal decline begins. We would also buy June Hogs, which should hold its value better because of the expected increased demand in late spring and summer. If we expect prices to be weaker for Hogs in December and January, you want to be short the February contract. If we also expect the prices for Hogs to hold their value for the spring and summer high season, we want to be long the June Contract.

We can even go back and look at how this spread trade has performed historically. In the past 15 years, if you entered this spread in the beginning of December and exited in the second week of January, it would have been a winner or scratch trade 15 out of the past 15 years. The average profit over that time was about $800 per spread. Now, it might not work every year, and there is always risk in any trade, but you have to like those odds over the long haul.

Below is a chart of the spread this year. In the beginning of December, the spread was trading about -13.000 (meaning that Feb 11 Hogs were trading at a 13.00 pt discount to June Hogs). February Hogs were trading at 76 cents per pound and June Hogs were trading at 89 cents per pound. 89 cents (June) – 76 cents (February) is how we come up with 13.000 cents difference in the spread between the two contract.

If the seasonal pattern holds true, we would expect the spread between the two to widen as February continues to have selling pressure while June has buying support. By the second week in January, the spread was trading at about -14.500. Feb Hogs were at 81 cent per pound while June Hogs was at 95.50. While the hog market rallied overall, June increase more than February, which is what we want to see (much like how Goldman would outperform Bear Stearns when the business conditions in banking were bullish). The spread widened, meaning June Hogs appreciated over Feb Hogs, to -14.50 cents. The spread widened by 1.5 pts, or $600 (each full pt in Lean Hogs is worth $400). Not quite the 15 year average of $800, but we will take it!

While this trade ended up being a winner, there is always risk. Notice that this position was not a winner the entire time of the trade. Towards the end of December the spread narrowed to -12.25, which would have put the position down $300 at its lowest point.

February 2011 vs June 2011 – Lean Hogs Futures Scpread Chart

Click to View Larger Spread Chart

Why Seasonal Spreads Work

As you can see, contract months in the same commodity can widen and narrow materially. These moves are what allow us to take advantage of seasonal opportunities (it also presents risks of loss too!). The best part about seasonal spreads is we can review different markets that have well known seasonality trends. We know what the historical risks are, the historical performance, and we can be confident that our trades are well thought out with defined risk and reward parameters.

Learn More About Seasonal Trading

If you would like to learn more about seasonal spread trading, please register for a complimentary subscription to my Turner’s Take Newsletter. You can also read a previous article I wrote called The Wonderful World of Futures Spread Trading. In my Turner’s Take Newsletter, we review the commodity markets once a week and look for futures spread trading opportunities. Not only do we look for spread trades, we also explain the seasonality, why the trade should work, and provide as much education as possible for our readers to feel comfortable and confident using this great trading strategy.

The Wonderful World of Futures Spread Trading