Spread Trading
Information


It is quite interesting to note that little is known about spreads in view of the fact, so many people are now interested in trading forex contracts.  In every sense of the word, each currency pair traded in forex is actually a spread between the two currencies involved.

The factor that differentiates spreads in forex currency contracts, from spreads in currency futures contracts is that futures spreads are based on the arithmetic difference between the two currencies, whereas forex spreads are based on the ratio of one currency to another. On a physical basis, both legs of a futures spread occur in separate markets, whereas forex spreads take place as a single entity in a single market.

The result is that futures spreads are graphed as line charts, having only a close with no open, high, or low, whereas forex spreads are graphed in the usual manner showing an open, high, low and close.

How and where do you look for profitable spreads?

There are a number of situations that create profitable spread trading opportunities. Let’s look at them now:

1.      Beginning of Backwardation (Inverted market)
2.      Ending of Backwardation (Inverted market)
3.      Seasonality
4.      Correlation
5.      Observation


BACKWARDATION

The normal pricing of storable and re-deliverable commodities is that the front (spot) month is lower in price than that of the more distant months.  This is due to the fact that there is a premium to pay for storage, insurance, and interest. The further distant is the delivery date, the more expensive it is to carry the underlying and the higher are the “costs of carry.” When the pricing structure is normal, prices are said to be in “contango.”

Just the opposite is true for financial futures contracts—since the only carrying charge is that of interest, and the interest is expected to be received, not paid at delivery time, contango exists when the price of the front month is higher in price than the months further distant of the underlying financial instrument.

From time to time, due to fundamental factors, such as abnormal weather, war, speeches by officials, or unusual breaking-news items, the demand for immediate delivery becomes very great and the situation in the front month changes.  For storable and re-deliverable commodities the front month begins to be priced higher than the more distant delivery months, and for financial instruments, the price for the front month begins to be priced lower than the more distant delivery months.  When this happens, prices are said to be in “backwardation.”


Beginning of backwardation

The beginning of backwardation in a commodity gives an opportunity to enter a profitable spread, by going long the front month and short the nearby or even further distant month.  The beginning of backwardation in a financial instrument offers the trader an opportunity to go short the front month and long the nearby or even further distant month.


Entering a spread

Entry can be given as a single spread order or by entering each market separately (“legging in”).  Even when legging in, the back-office computers will have been programmed to recognize the two contracts as being a spread and if reduced margins are applicable, reduced margins will be applied.  Reduced margins give the spread trader considerably more leverage than do regular futures margins.


Exiting a spread

To exit a spread simply do the reverse of what was done in order to enter a spread—sell the contract month you were long and buy the contract month you were short.  Once again, this can be entered as a spread order or by entering each contract individually by legging in.


Ending of backwardation

As the conditions which caused prices to go into backwardation end, and as prices return to their normal relationship (contango), spread traders have another profit-making opportunity.  As backwardation ends, doing the opposite of what was done at the beginning of backwardation has the potential to result in excellent profits.


SEASONALITY

Seasonality in spread trading has consistently proven to offer profitable opportunities for entering spread trades. Under normal circumstances, seasonal factors are highly reliable indicators of what will happen regarding the relationship between the months of a particular underlying, whether that be a storable or re-deliverable commodity, or a financial instrument.

The relationship between crops which have been harvested and are now in storage, and the next crop, which has just been planted (old-crop, new-crop), offer excellent spread trading opportunities.

Seasonal trades exist between markets as well.  When wheat is being harvested, pressure will be on the wheat crop for lower prices, while at the same time it is unknown as to the harvest realities of both soybeans and corn. Selling short wheat and going long soybeans or corn during the wheat harvest can be profitable provided that there is no existing or anticipated shortage of wheat, along with no huge oversupply of soybeans and corn.

People often ask whether there could possibly be seasonality in financial instruments, and the answer is most definitely, YES!  There is seasonality in and among a variety of financial instruments.  Currencies, stock indexes, bonds, notes and all other interest related financial futures all display seasonal tendencies.

For many years US dollar gyrations have rocked foreign exchange markets, driving most major currencies higher against the dollar.  But some currencies have enjoyed greater benefit than others.  Some foreign economies, for example, have been strong enough to give official rise to concerns of overheating.  In contrast, other economies are best described as having seen better days.  Thus, the currency that is strong will generally outperforming the currency that is weak, giving rise to an excellent spread opportunity.


CORRELATION

Spreads are often entered into because of correlation with prior years.  For some underlying fundamental reason, not necessarily known to us now, a spread is behaving in the same way it did in one or more previous years.  The correlation is discovered through the process of regression analysis.  The correlation often gives rise to extremely profitable spreads, with no need for the trader to understand or even know what happened in the past to cause the spread to behave the way it is anticipated to behave in the future. 

Note: Both Seasonal and Correlation spreads give the trader days, weeks, and even months in advance to plan a trading strategy and the tactics that will be used to implement the strategy.
 

OBSERVATION

Sometimes spread opportunities are simply obvious.  For instance, there are times when one stock index is clearly outperforming another stock index.  At such times, a spread between the two offers outstanding profit opportunities. It is often quite clear that the E-mini S&P 500 is outperforming the E-mini Nasdaq 100 (the reverse can be true also).  A spread between the two will yield excellent profits, yet the margin for the spread holding overnight, is only a fraction of the margin for trading in the individual futures.

Every spread we’ve mentioned has reduced margins, which means you could have received 2-5 times more leverage than by trading an outright futures contract.

At one point in time for example, Soybean spreads were quite active and trending.  For soybeans, margin was only $743 for the spread whereas margin for the outright contract was $2,025. Soybean futures would have to make a move almost 3 times greater than did the spread for it to have been worth risking the outright futures.  Spreads generally have lower risk than outright futures.

Spread trading is something that every trader should at least consider looking into. However, do not confuse spread trading in futures with the “spread betting” that takes place in the UK.  They are entirely different one from the other.

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