As many basketball fans may know, the Miami Heat recently had a 27 game winning streak, which was the 2nd longest winning streak in NBA history. It ended on Wednesday, March 27, 2013 when they visited my Chicago Bulls in a game that a lot of folks thought the Heat should have won easily.
The Chicago Bulls were set to play the game without their superstar Derrick Rose, All-Star center and arguably the heart of the team, Joakim Noah, shooting guard Rip Hamilton and shooting guard Marco Belinelli.
The Heat, lead by LeBron James, Dwayne Wade and Chris Bosh, was at full strength and playing like a well-oiled machine.
So why am I mentioning this on a futures trading blog?
Good question. The point spread on this Heat vs. Bulls game was -5, meaning that the Heat were favored by 5 points. Because the Bulls were missing key players and Miami appeared untouchable throughout their win streak, many in the sports gambling world thought the Heat would win by much more than 5 points. Indeed, they viewed this 5 point spread to be inaccurate and believed that it should be much larger.
To be clear, I’m not comparing gambling on a basketball game to futures trading. Rather, I intend to use the point spread for the Bull vs. Heat game for educational purposes, because the concept of a point spread in this basketball scenario is similar to spread trades in futures. Unquestionably, futures trading is more sophisticated, and when investing in futures and options you can lose more money than you initially invested. Further, you should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources.
So let’s look at the spread between two contracts (teams) in Heating Oil, December (the Heat) versus July (the Bulls). On March 12, 2013, the price of a December Heating Oil futures contract was 3.0631, the price of July was 3.0181. As such, the spread, or difference in price between the two contracts, was .0450.
This is a summer vs. winter spread. In Heating Oil, quite naturally, the consumption is greatest in the winter month, and as a result the market often builds a premium into the December and nearby contracts relative to other months. So in this spread a trader would buy December.
As for the short contract, July, this one tends to stay under pressure, relatively speaking, given reasonable supply. Strong demand for gasoline in the summer means that heating oil, essentially the by-product of gasoline is plentiful. More supply means that there will be lower prices, so a trader would sell July.
On March 12, the spread between December and July is at .0450. Based on our understanding of fundamental knowledge in Heating Oil, we recognize that the spread is too big and should be smaller. This is a lot like how many folks thought the Heat would beat the Bulls by more than 5 points leading them to place their money on the Heat.
Thanks to some tough defense, great shooting and superior coaching, the Bulls bullied, outworked and beat the Heat 101 to 97. So the Bulls wound up covering the spread by winning outright by 4 points.
As of March 31, the July Heating Oil contract did the same thing and outpaced the December to the downside in price, since we put our spread on.
Initially trading at 3.0631, the price of July Heating Oil dropped to 3.0280, and since we shorted July, this was a positive $1474.20 move for the spread. Conversely, we went long December, which initially traded at 3.0181 and dropped only to 3.0124 during this time period, which resulted in a $239.40 move against the spread. The spread between the two contracts narrowed to .0156 (3.0280 – 3.0124) and resulted in a successful trade to the tune of $1234.80 ($1474.20 – $239.40).
Hopefully the concept of a point spread in this basketball scenario has shed some light on how trading a futures spread can be similar. Don’t forget though that there is substantial risk of loss in trading futures and options. December did not outpace July to the downside making our trade a winner. The Heat did not outgain the Bulls on March 27, 2013, resulting in a loss for folks putting their money on the Heat and a win for the Bulls.