The sayings go, “you can’t teach an old dog new tricks” and “if it isn’t broken don’t fix it”. We get it â€“ we will leave the old dogs alone. Then again, how come no one ever talks about teaching new dogs old tricks? There is a trading style, as old as the exchanges themselves, that is constantly ignored by many who try to master the markets â€“ spread trading.
Spread trading has been around for as long as there have been more than one market; and for those who don’t like to see big swings in their accounts from massive daily market moves due to recessions, QE hype and all types of headline risk, it might be a style worth exploring.
In the trading world, the word “spread” is tossed around frequently. Essentially, it is defined as the difference between two prices. Many refer to the spread as the bid/ask on a contract or option, some refer to spreads when talking about the differences between 2 option prices, and even more will talk about a spread being the difference between two futures contracts. Whatever the reference, it is important to understand that when trading the futures spreads you will end up with one of the following positions:
- Intra-market Spread: Long Dec Corn, Short July Corn
- Inter-market Spread: Long Dec Corn, Short Nov Soybeans
- Inter-exchange Spread: Long KC Wheat, Short Chicago Wheat
When spread trading, it is paramount to get into these spreads simultaneously. Effective spread traders will use spread order entry tools from either the platform or the floor to enter positions. Keep in mind that we are trying to make a profit only from the price movement between the two contracts being spread. It makes no difference whether soybeans go to zero or to infinity â€“ all I care about is how that would affect the difference between the two prices of the different soybean contracts and whether I would be long and short. This takes a lot of the “outside market” pressure we hear so much about out of play.
Here are other key benefits of market spreading:
- Spreads, especially intra-market spreads, have lower margins. A corn contract has an initial margin of $2362 while the spreads in the same crop have an initial margin of $1013.
- Because of that lower margin, the rate of return on an investment might be higher. This is from posting a lower margin for hopefully the same returns.
- In my opinion, seasonality plays tend to be more consistent with spreads rather than outright positions because they shield a lot of outside market exposure.
- Spreads reduce some of the currency risk. Essentially, every outright trade one enters is a spread trade. If you buy Corn, you are long Corn against the US Dollar. The dollar falling or rising has just as much an affect with the underlying corn price as the cash market corn does. Spreading eliminates this because you are long and short instruments that are both priced in dollars.
These are just a few benefits. To learn more information on spread trading and how you can diversify using them, contact a Daniels Trading broker. Even old dogs might find that switching to spread trades is a trick worth learning, especially in these choppy markets.
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