Futures spread trading is a unique discipline that offers many benefits to practitioners. Featuring reduced margin requirements, extensive strategic applications, and limited exposure to systemic risk, spread trading is viewed by many traders as a premier financial strategy.
Limited Systemic Risk Exposure
Aside from being a catch-all term, risk comes in a variety of forms. Financial, currency, and commodity risks are several that are common in the futures market. However, systemic risk—the danger of a market-wide or sectoral meltdown—is the type that most concerns traders and investors. In futures, systemic risk is the possibility of an asset class experiencing a crash in pricing.
Those involved in futures spread trading can largely avoid systemic risk by simultaneously buying and selling related contracts. A spread consists of two offsetting positions, known as legs, that mitigate exposure to either the bullish or bearish side of the market.
The mechanics of a spread are very different from those of outright futures. In the case of outrights, rising and falling prices directly impact P&L and boost risk exposure. For spreads, a position’s upside and downside risks are essentially covered. Therein lies the crux of spread trading: Dramatic spikes or plunges in asset pricing have a negligible impact on the spread’s aggregate value. What really matters is the pricing of each leg relative to the other.
In practice, traders may use different futures spread trading strategies to produce consistent returns. However, all of these strategies fall into one of these categories:
- Intramarket: Also known as calendar spreads, intramarket spreads involve the buying and selling of the same contract with different months. For instance, if you bought one lot of January 2020 WTI crude oil and sold one lot of March 2020 WTI, you would be executing an intramarket WTI spread trade. Intramarket spreads are regularly used by long-term traders to manage futures contract rollover and extend their investment horizon.
- Intermarket: Intermarket spreads are executed by buying and selling two different-but-related products with the same expiration dates. A common example of an intermarket spread trade is to buy December corn and sell December wheat. This wheat/corn spread offers producers insulation from erratic commodity prices and gives speculators an opportunity to profit from market variations.
- Commodity: Commodity spreads are executed by buying contracts that pertain to the processing and manufacturing of raw materials. To execute, a trader buys the underlying commodity contract and sells the manufactured product. As an example, assume that Erin the energy trader buys one contract of January 2020 WTI crude oil while simultaneously selling one contract of January 2020 RBOB gasoline. Erin will profit from the trade if the two legs of the spread converge (rising WTI and falling RBOB prices).
Countless intramarket, intermarket, and commodity spread strategies exist, and they offer interested parties many opportunities. For those seeking trading/investment alternatives, few instruments match the versatility of spreads.
Reduced Margin Requirements
Due to the limited risk exposure, futures spread trading furnishes participants with vastly reduced margin requirements. Trading futures outright can be capital intensive; spreads are typically offered at a fraction of the financial commitment.
To illustrate this point, let’s examine the margin requirements for a CL Light Sweet Crude Oil intramarket futures spread:
- Spread: For the December 2019/January 2020 listing, maintenance margin requirements are $350.
- Outrights: To execute each leg of the December 2019/January 2020 spread using outrights, the maintenance margins of each leg are $4,350 and $4,200. A total of $8,550 is needed to execute the trade.
In the example above, the diminished margin requirements of the spread are a direct reflection of the much smaller risk exposure. This is a big advantage to the trader because opening new positions in the market requires only a minimal capital outlay.
Adding Futures Spread Trading to Your Financial Plan
For more than 20 years, the team at Daniels Trading has specialized in helping individuals achieve their financial goals via standard futures, options, and futures spread trading. To learn whether spreads are right for you, take advantage of Daniels Trading’s second-to-none service suite and schedule your free, no-obligation consultation today.