Once reserved only for institutional traders, spreads are gaining popularity among retail participants around the globe. Reduced margin requirements, limited risk exposure, and diverse strategic alternatives have made spreads an ideal destination for legions of active futures traders.
Spread Trading 101
The first step in learning how to trade futures spreads is to address their three fundamental classifications: intramarket, intermarket, and commodity product. In order to execute each type of spread, it’s necessary to simultaneously buy and sell futures contracts in the same or similar markets. To execute each type, assume that Sam the spread trader takes the following measures:
- Intramarket: Sam buys and sells the same futures contract with a different expiration month.
- Intermarket: Sam buys and sells different, but related, futures contracts with the same expiration month.
- Commodity product: Sam buys and sells futures contracts that are related to the processing of raw materials. As an example, Sam could buy soybean futures and sell soybean oil futures to execute a “Soybean Crush” commodity product spread.
Though spread strategies vary greatly, almost all fall within these three categories. If you were to sign up for a weekend seminar titled How to Trade Futures Spreads, these terms would be covered on day one.
One of the premier advantages of trading outright futures and futures spreads is the abundance of strategic possibilities at your disposal. In many ways, the trader’s imagination is the only limit.
However, there are spread strategies that have stood the test of time. Here is an example that people who know how to trade futures spreads have historically found useful.
Gold Bull Spread
One way that risk-averse traders use spreads to secure market share is through the gold bull spread. This strategy is an intramarket spread, meaning that offsetting positions will be taken in the same contract with different expiration months.
The objective of the gold bull spread is to benefit from rising prices in the short term. To accomplish this goal, Sam the spread trader executes the strategy per the following:
- Sam buys one lot of 2019 CME December gold futures (GC) at $1475.0.
- Concurrently, Sam sells one lot of 2020 CME February gold futures (GC) at $1485.0.
- Sam observes price action, follows the news, and reads expert blogs on bullion.
- Should the price of December gold rise faster than that of February gold, Sam will profit from the action.
Gold bull spreads are often applied in anticipation of forthcoming risk. If the capital markets become suddenly turbulent, the long gold position will very likely appreciate faster than the short. The result is a net gain from the difference in contract values.
Understanding the Risk
Any thesis on how to trade futures spreads had better address the topic of risk. Perhaps the largest benefit to spreads over outrights is the limited risk exposure. Holding both long and short positions in the market protects against disaster, greatly limiting downside exposure.
Regardless of strategy, every trade comes with a degree of risk. In the gold bull spread above, Sam is opening conflicting positions in the same market. How could a loss possibly be sustained? Here’s how:
- Extraordinary event: An unexpected dose of good news could reduce perceived risk in the market. Subsequently, the long position may lose value faster than the deferred short gains value.
- Reckless leverage: By nature, spreads have vastly reduced margin requirements. Still, when position sizes become too large, extraordinary losses are possible. If Sam bets the ranch on a gold bull spread and the trade doesn’t go as planned, substantial loss or drawdown are the consequences.
Learn How to Trade Futures Spreads from an Industry Pro
The beauty of spreads is that their application is not limited to one asset class. No matter whether your expertise is in commodities, bonds, or equities indices, spreads offer countless strategic possibilities.
Of course, before you can profit from the inherent opportunity, it’s necessary to learn the basics of how to trade futures spreads. For more information, contact a Daniels Trading industry professional today.