Greetings traders and welcome back to another In-Depth with Chris episode.
In today's discussion, we will be talking about futures spread trading.
This is the simple concept of looking to go long and short
at the same time. While we're pointing down, please click that like and
subscribe button down below because it allows me to keep
coming out with information for you guys.
Without further ado, let's cover what we're going to
talk about, and that is exactly how future spread trading
works, what it is of course, as well as how strategies employ the
concept of futures spread trading.
It is, after all, considered to be one of the safest forms
of arbitrage trading that exist today, and as such, it could
be something very useful for those of you looking to pass the Gauntlet Mini.
Without further ado, let's dive on into that material
and learn about future spread training.
Futures spread trading is considered to be one of the safest
commodities trading strategies that exists out there for the futures market.
It is a very valuable tool, when understood and implemented
correctly, because it allows you to go both directions in
the market. If you're going both directions, you can't lose right?
Well, not entirely, but the idea is still a very valuable one
indeed. First, what is a future spread? A future spread
is a trading technique that the trader is going to open a long
and a short at the same time in order to take advantage of
a price discrepancy, with a key word being, this price discrepancy.
We want to focus on that, so let's continue on with this.
The idea is, quite simply, that we're trying to reduce the
risk that we're exposed to while at the same time capitalizing
on the pricing inefficiencies for one or several instruments.
Spreading is applied on a variety of different asset classes,
but mostly within futures trading and commodities in general.
A while ago, due to the market structure, the spread trading
ideas were really only available to institutional and large-scale
traders, but with the development of trading as it has been
over the last 10 to 15 years,
we have seen that market open up to retail traders like you and I.
Futures spread trading strategies are always gaining
popularity due to their ability to mitigate risk. Traders
are always out there trying to find ways to potentially curb
some of that risk, without necessarily hurting some of their profits.
Let us imagine how a futures spread works. The main
idea of a futures spread trading strategy is to capture the
difference between the price of the contract that is being
sold, and the price of the contract that is being bought.
Usually, this works when we are trading futures that have different expiration dates.
For example, a futures spread could be when we go long
on soybean futures, and we go short on soybean futures at
the same time with different expiration dates. The buy and
sell positions that a trader opens at the same time are acknowledged
as a single position, which is called a "unit trade." The buy
and sell sides of the unit trade are usually called "legs."
The goal of the trader placing the unit trade is to see
the long side of the spread increase in relation to the short
one. That way, the spread between the positions guarantees
he captures a bigger profit, or she for that matter.
Depending on the traders preferences about the type of commodity he
or she wants to offset, its stay, in the exact strategy on how they want to trade it,
they can choose from three different types of futures
spreads. We have inter-commodity futures spreads, intra-commodity
futures spreads, and commodity product spreads. Aside from
these, you also have less talked about spreads such as bull
and bear futures spreads. The difference between both is that
in bull futures spreads, the goes long on the near month and
shorts the deferred one. While in bear futures spread,
he goes long on the deferred month and shorts the front month.
Now as we talk about these three ones, which are the main
three, we're going to focus on inter-commodity futures spreads first.
Inter-commodity futures spread is the type where
contracts on various commodities are utilized with the same month.
For example, when you simultaneously open positions to buy corn
futures and sell wheat futures, both of which expire in
September, this would be an example of an inter-commodity futures spread.
We also have intra-commodity futures spreads down here at
number two. An intra-commodity futures spread,
what we're doing is, we're buying and selling the same commodity, but with different months.
For example, a trader may buy an April soybean futures contract
and sell an October soybean futures contract. In this case,
the legs of the trade, spread between different months rather than different instruments.
This is also sometimes referred to as a calendar spread.
Calendar spreads are considered easier to trade, as the trader should
specialize only in a single commodity because they're trading
the same commodity, but just doing it at different times.
By learning all about the different price factors like seasonality,
supply and demand, weather conditions, etc.,
you can focus on just one, and that's less information to
digest in general, and that at least is the idea behind why
the intra-commodity futures spread isn't overly difficult when compared to the others.
Then finally, we have the commodity product spread.
The commodity product spread reflects the difference
in the commodity's price in its raw form and as they finished product.
Commodity products spreads are usually used as a
frequent choice by traders that are interested in, say, oil,
and the agricultural industry. Traders usually enjoy the type
of commodity product spreads offered here, and trade them
by going long on the raw material and then shorting the finished product.
Now, the way that they profit basically replicates
the profit margin of the company that handles the whole process.
We want to bear in mind that this type of futures spread
is usually more of an exotic instrument, and it's not as powerful
as, say, an intra commodity future spread.
Margin requirements are a crucial thing that any trader interested
in futures spread trading should definitely be aware of.
They indicate the level of volatility and risk associated with
the underlying commodity, or the relationship between the traded assets
if there is more than one. Futures spreads' margins are usually
lower than those of traditional futures contracts, as they
bear less volatility and hedge against systemic risk.
In the case of an unexpected event like a terrorist attack,
or a stock market crash, a war breaking out, or a default of
a country for example, both legs of the unit trade should
be affected equally. That way, the trader won't incur any losses.
Let's paint this difference in some type of numerical fashion, shall we?
If we were to say that Joe wanted to trade corn and
wheat with a spread strategy, we could say that the margin
for corn futures is set at $2,000, while the
one for wheat is currently at $1,000. Instead of posting $3,000
total to trade the spread on two contracts, Joe can just simply
receive a 75% margin credit. This means the initial margin will equal just $750,
which is substantially less than the $3000
we might have initially thought. What this comes to show is
the massive difference in terms of the margin requirement
when trading single contracts out right, as opposed to trading them as a spread.
Often, depending on the instrument, the futures spread margin can
be as low as just 10% of the value of the margin requirement for a single contract.
Before trading, it is essential to check with your brokerage
service provider to determine the current margin requirements
that you will need to comply with when trying to complete a futures spread.
Here we have a list of some very popular spread options out
there to choose from. Of course
this does not include every possible outcome, or every possible
spread that you could conceive of, but instead this is just
to give you an idea of how they work and show you some examples.
The first is going to be, say, a July corn in a December corn
futures contract. That could be a spread choice. Naturally,
the degree of what kind of spread you choose to employ will
vary based on these as well.
We also could do something like a soybean and corn spread, or we
could do a Kansas City wheat and a Chicago wheat spread. We
could do a natural gas as the raw material and
electricity as the finished product for another type of spread,
obviously, if we're changing it between the raw and the finished
form like we talked about. We could do crude oil as a raw
material and petroleum products as a finished product.
We could do soybean as a raw material and soybean oil as the finished product.
We can do fed funds and euro dollars, and remember euro dollars
are the American dollars held overseas. Then we have the 2-year T-note, as well as the 5-year T-note.
The list just goes on and on. The idea is that traders can
shape their preferences depending on the type of spread that
they're interested in trading, as well as the specifics of the underlying asset.
This will give you the idea and the understanding in order
to implement perhaps your very own spread that isn't even
listed here. Depending on whatever it is that you're interested in trading,
there is a good chance in the futures world that you might
be able to find a way to spread it,
especially if it happens to be in the commodity sector.
In the end, no matter what spread you want to trade, or are trading,
we want to make sure that we put our primary focus on the
relationship between both legs of the spread, rather than
the overall direction of the market. If the spread is good
enough, you will be making money in downward markets as well.
Even though that trading spreads is less risky than buying
and selling a single futures contract, trading futures spreads
still requires a substantial degree of expertise and attention
to detail. The first step to becoming a successful futures
spread trader is to get familiar with the primary factors
and characteristics of the different commodities or instruments
that we are willing to trade. We have three of the most common listed here for you.
The first is something called seasonality.
First and foremost, consider the time of year and how it may
affect the price of the instruments that we are willing to
trade. Whether we are buying or selling single futures contracts,
or trading futures spreads, seasonal factors are among the
detrimental ones for the instrument's price, regardless of the style,
so of course, it is important to be aware of this.
The reason is, seasonality determines supply and demand.
Some commodities like natural gas for example, may be higher during
the winter months, while others like crude oil may be higher
during the summer months. On the other hand, a warm winter
can reduce the demand for gas and heating oil.
It's important to be aware of the correlation between
seasonality and whatever it is commodity that we are trading.
The political situation and macroeconomic conditions are
also something to make sure that we pay attention.
to. It is essential not to only focus on the specific characteristics
of a commodity, but also to keep an eye on the macro factors
that might affect our spread. This includes trade wars,
embargoes, global political instability, interest rate policies,
financial and economic crisis, region specific developments,
the list goes on and on. This is crucial for all types of
future spreads, but most importantly, inter-commodity and
products spreads. In the case of an intra-commodity product
spreads, although there would be some difference, the overall
effect should be equally comparable with both legs of the
trade. For example, if we were trading April and August
crude oil, and some instability in the Middle East arose, then
the spread between the buy and sell order should remain the
same. Then finally, we have stay informed about the industry.
Financial and commodity markets are very dynamic. Things can
change from day to day, and if you want to succeed as a futures
trader, you should keep track of the news and updates regarding
the industries that you are interested in. The best way to
do that is by accompanying your morning coffee with an official
industry analysis report. It may not sound that exciting,
but it will set you on a better path to success if you are
staying informed about the various industries out there.
As you might imagine, there are many advantages to trading futures spreads.
However, I outline my favorite three. The first being the
fact that it is a better risk/reward ratio than trading single futures contracts,
and this is a very powerful one. If we have a better risk/
reward ratio, it in turn makes our requirement for success
that much easier to achieve because our requirement to succeed
doesn't need to be as high as if we were trading with a lower risk/reward ratio.
We also have the fact that price movements are easier to forecast
while we are trading with a spread. Trading futures spreads
makes it easier to predict how the different contracts, the
legs of the trade that is, will react to particular events
during both bull and bear markets,
the nearer contract's price is usually more affected than the
one of the longer term contract.
Finally, we have a good field for beginners to make their
first step. This really ties a lot into the number one here.
The fact that the risk/reward ratio is so good, relatively to trading single contracts,
it allows us to not have to be as high of a degree of a professional
trader, nailing trades at such a high degree of accuracy, in order to be profitable.
That means that it is more beginner friendly because we don't
have to be as good with our speculation.
Now, that does not mean necessarily that it is any easier,
and there is actually more work involved in trading a spread
because you are trading two trades instead of one, in theory
of course, but the idea is the requirement for success, once
understood, should be easier on the beginner approach.
As far as the disadvantages go, there were really
only two that I thought were worth mentioning.
The first one is the fact that more trades does equal more commissions.
If we're making more trades,
we are paying more commissions. That is just a simple fact.
That is arguably the biggest drawback of futures spread
trading. That means, each trade consisting of two legs, which
is buying and selling an instrument, basically doubles are trading fees.
If we don't take this into consideration, we might be
unhappy when we realize that our profits aren't as high
as we were initially expecting them to be because of the
commissions paid. The number two is it may lack liquidity.
Often futures spreads are less liquid than trading other instruments,
or even single futures contracts. This may turn out to be a problem for traders who rely on
having to get in and out of a position extremely quickly.
To sum it all up, trading futures spreads is a very
valuable tool to be aware of, and as such, I thought it was
extremely important to bring it to you guys.
It's a way that you can potentially reduce a ton of your
risk, without necessarily inhibiting your ability to still
profit from the markets. In some cases,
it can be an even more profitable way to go about trading
than what traders are already doing.
Ultimately, you'll have to decide if it is right for
you, and if you are interested in trading it, I
wish you the best of luck of course, and until next
time folks, please make sure you click that like and subscribe button
down below if you haven't already, and I will see you soon.
Cheers folks and happy trading!