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 Futures Spreads
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.
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.
