One of the great things about futures contracts is their inherent flexibility. This attribute opens the door to a vast catalog of strategic opportunities. Unlike other financial instruments, it doesn’t matter if you favor the long or short side of the market―money can be made from rising or falling prices.
For those who believe a specific market is destined to rally, bull spreads are a great way to capitalize on the idea. In this post, we break down the mechanics and benefits of this time-tested strategy.
Bull Spreads 101: Trade Execution
Bull spreads are types of futures strategies in which a trader buys near-month contracts while selling deferred-month contracts of the same product. To illustrate the strategy’s functionality, assume that Sawyer the stock trader expects a big year out of the S&P 500. Subsequently, Sawyer decides to execute a bull spread using E-mini S&P 500 futures. Here’s how:
- On April 15, Sawyer buys 10 contracts of June E-mini S&P 500 futures.
- Also on April 15, Sawyer sells 10 contracts of December E-mini S&P 500 futures.
- When both orders have been filled, the bull spread is opened.
After looking at Sawyer’s trades, you may be wondering how he can make money from holding long and short positions in the same market. Isn’t the position net flat?
Not exactly. Remember, a futures contract is an agreement to buy or sell an asset at some point in the future. Thus, the contract’s price isn’t congruent with the underlying asset’s spot price; it is a representation of what the market believes the contract will be worth at expiration.
Given the structure of a bull spread, the near month’s expiration is closer than that of the deferred month’s. Accordingly, the near month contract’s price (long position) is more sensitive to market forces than that of the deferred month (short position). This is how bull spreads make money―as prices rise, the gains realized from the near-month long position outpace the losses sustained by the deferred-month short.
Why Execute a Bull Spread?
So why do traders execute bull spreads instead of simply buying a desired futures contract? If Sawyer believes that the S&P 500 is going to rally, why not buy the E-mini S&P 500 contract and wait for the price to tick higher?
The answers to these questions center on the essential benefits of spread trading. Here are a few of the key advantages spread trading provides traders:
- Limited risk: When you simultaneously hold both long and short positions in a specific market, the odds of financial catastrophes are slim.
- Small margins: Because of the lower-risk profile of spreads, margin requirements are immensely reduced.
- Strategic flexibility: Lessened margin requirements free the trader to explore methodologies that involve holding live positions for days, weeks, or months. Subsequently, spreads open the door to many trends, swing, and long-term trading strategies previously off the table.
- Product diversity: Spreads may be executed against a variety of asset classes. If it’s listed on the Chicago Mercantile Exchange (CME), then chances are it can be traded via spreads.
The reduced risk exposure, low margins, and flexibility make bull spreads ideal for traders that favor the long side of a market. If you’re bullish in equities, commodities, currencies, or debt, then this strategy may be worth incorporating into your trading plan.
Getting Started with Spreads
Futures spreads furnish traders with many ways of capitalizing on the volatility of the world’s leading asset classes. Regardless of your market view or area of expertise, spreads are a viable means of securing market share.
For more information on spreads and much more, download a complimentary copy of Daniels Trading’s Futures & Options Strategies Guide. Featuring 21 time-tested futures and options strategies, it is a great starting point for your journey into the marketplace