In the world of finance, “spread” has several definitions, every one unique to the specific asset class or security being traded. Although each of the interpretations varies in comparison, a spread is essentially the difference between two quantified values.
Here are the asset-specific applications of the spread concept:
- Equities and currencies: A spread in the equities or forex market is the difference between the lowest ask price and the highest bid price of an individual stock or currency pairing.
- Derivatives: In futures and options trading, a spread is an active position in the market that results from the buying and selling of two or more related contracts. Typically, the products involved in the spread exhibit contrasting expiration dates.
- Debt instruments: A spread is the discrepancy in yields between two similar notes or bonds.
- New stock issues and IPOs: During a company’s initial public offering (IPO), or any new issuance of stock, a spread is the difference between the price a company sells its shares to an underwriter (investment bank), and the markup that underwriter offers the shares to the public.
Implementing a trading strategy based upon spreads in the equities and debt markets is often exclusive to high net-worth traders and institutional investors. However, incorporating spreads into a futures trading strategy can be an efficient way for individual retail traders to engage opportunity within the marketplace.
Futures Spread Trading
In the trade of futures, a spread consists of simultaneous long and short positions being opened in a specific product or multiple correlated products. In contrast to producer hedging, where offsetting positions are assumed in both the cash and futures markets, all active positions are exclusive to futures.
There are four basic classifications of futures spread trading strategies:
- Intracommodity Spreads: Intracommodity spread trades occur when a trader or investor takes an offsetting position in the same product using contracts with different expiration dates. Intracommodity spreads are also referred to as calendar spreads.
- Intercommodity Spreads: An intercommodity spread trade occurs when a trader takes opposing positions in different, but related, products.
- Bull Spreads: A bull futures spread occurs when a front or near front-month contract is purchased, while a contract for the same product with a longer duration until expiry is sold.
- Bear Spreads: A bear futures spread occurs when a front or near front-month contract is sold, while a contract for the same product with a longer duration is bought.
Mechanics of a Futures Spread Trade
The mechanics of a futures spread trade vary according to the complexity of the strategy, but the basic transactions are relatively straightforward.
Assume that a veteran trader has decided to execute a seasonal spread trading strategy for August and November soybean futures on the CME globex. Initially, long and short positions facing the desired contract months are opened:
- A standard calendar spread order is entered at the exchange for August and November soybeans, effectively opening a synthesized position.
- One contract of August soybeans is purchased at a desirable price, creating an active long position.
- One contract of November soybeans is sold at a desirable price, creating an active short position.
This particular trade is classified as an intracommodity spread because both positions involve soybean futures. In addition, it is a bull spread, meaning that the goal of the trade is to capitalize upon rising soybean prices in the near-term.
Advantages of Futures Spread Trading
The soybean spread outlined above provides the trader several advantages over simply taking a definitive long or short position in the market:
- Reduced margin: The trade’s maintenance margin requirements have been decreased from US$2100 per contract to a total of US$550.
- Systemic risk management: Upon the trade becoming active in the market, the trader is effectively protected against the inherent systemic risk facing the trade. If any unforeseen macroeconomic or geopolitical issues greatly impacts the soybean market, then the opposing positions will mitigate a majority of the risk associated with enhanced pricing volatility.
- Ease of transaction: Exchange-based order entry options streamline the process of trading spreads, limiting transaction complexity.
Futures spread trading, or spreading, provides traders and investors many methods of speculating, hedging, or managing an open position within a given market. It is a means of addressing risk while pursuing opportunity.
At the very least, the advantages of spread trading are worth investigation. Reduced margin requirements, risk management, and a wealth of trading alternatives make spreads a valuable part of nearly any comprehensive trading approach.