One of the main hurdles for traders that are new to futures spreads must overcome is the concept of futures spread pricing. For example, let’s say a trader wants to buy Sept Corn and sell Dec Corn. Sept Corn is trading at $5.00 and Dec Corn is trading at $4.75. How do you place the order?
I recommend reading my article on How Futures Spreads are Priced to gain a better understanding of futures spread pricing. If you understand how spreads are priced, you will know that if Sept Corn is trading at $5.00 and Dec Corn is trading at $4.75, than the spread price is a positive 25 cents, or +$0.25.
SEPT CORN ($5.00) – DEC CORN ($4.75) = $0.25
We know that Sept/Dec Corn is trading at 25 cents, but how do you actually place that order? You want to buy Sept Corn and sell Dec Corn, but is that 25 cents to the “buy side” or the “sell side”?
Buy/Sell Side Rule: Always put the price to the side of the contract that is trading higher!
In this example, SEPT CORN is trading higher than DEC CORN. We are BUYING Sept Corn and SELLING Dec Corn. Therefore, the price goes to the SEPT CORN on the BUY SIDE.
EXAMPLE: Buy Sept Corn and Sell Dec Corn at a 25 cent limit to the BUY Side.
Please note that it does not matter whether you are entering or exiting the spread, or if it is a bear spread or bull spread. All that matters is which contract is trading higher. The contract that is trading at a higher price is the determining factor on what side of the order ticket (Buy Side or Sell Side) the premium is placed.
Still not 100% clear? You are not alone. Let’s take an example from Major League Baseball to really drive the concept home. Let’s assume you are the General Manager of the NY Mets. You need a hitter and have too much pitching. The problem is the hitter you want is worth more than the pitcher you are willing to give up. For this example, lets say the hitter you want is worth $5 Million but you only have a $3 Million pitcher to offer. It does not look good for you!
Good news is the Chicago Cubs are willing to make a deal. The Mets (in this case—you) want a hitter and the Cubs want a pitcher. You offer the Cubs a pitcher for a hitter straight up. The Cubs think they are getting ripped off because their $5 Million hitter is a much better player than the $3 Million pitcher that you are offering. So the Cubs come back and say “You can have my $5 Million hitter, and we will take your $3 Million pitcher, but in return you are going to send us $2 Million cash to even out the trade.”
The futures spread markets work the same exact way. Instead of two GMs in the trade, there is only the trader and the market. In our Sept/Dec corn example, the trader is telling the market he wants to buy Sept corn ($5.00) and sell Dec Corn ($4.75). The market comes back and says “hold on a minute, I’m not giving you sept corn for dec straight up because sept is trading at a 25 cent premium. If you want sept in exchange for dec, you need to come up with another 25 cents.” And that my friend is how it is done. The order is “Buy Sept Corn & Sell Dec Corn at 25 cents to the Buy Side.”
I hope that helps shed some light on the concept of how futures spreads are priced for orders. Once you understand the concept behind the rules, it is much easier to price these orders on your own. Always remember, you are first exchanging futures contracts with the market, and then you have to make up the difference in value between the two, just like how they do it in the big leagues!
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