Futures spread trading is a popular trading strategy that involves taking two positions on a commodity to capitalize on a discrepancy in price. In this guide, we will explain everything you need to know about futures spread trading, including its definition, mechanics, and how to trade futures spreads.
Definition of Futures Spread Trading
Futures spread trading is an arbitrage technique in which a trader takes two positions on a commodity to capitalize on a discrepancy in price. In a futures spread, the trader completes a unit trade, with both a long and short position. The goal is to profit from the change in the price difference between two positions. A trader may seek to take a futures spread on an asset when they feel there’s a potential to gain from price volatility.
Mechanics of Futures Spread Trading
Futures spread trading requires taking two positions simultaneously with different expiration dates to benefit from the price change. The two positions are traded simultaneously as a unit, with each side considered to be a leg of the spread. The spread can be either a calendar spread or an intermarket spread.
Calendar Spreads:
Calendar spreads, also known as intramarket spreads, involve buying a futures contract in one month while simultaneously selling the same contract in a different month. This type of spread is used to take advantage of price differences between two contracts with different expiration dates. For example, a trader may buy a December futures contract and sell a March futures contract on the same commodity.
Intermarket Spreads:
Intermarket spreads involve simultaneously buying and selling two different, but related, futures with the same contract month in order to trade on the relationship between the two products. This type of spread is used to take advantage of price differences between two related commodities. For example, a trader may buy a futures contract for crude oil and sell a futures contract for natural gas.
How to Trade Futures Spreads
Trading futures spreads involves several steps, including:
Determine Market Conditions:
Before trading futures spreads, it is important to determine the market conditions. This will help you decide which type of spread to use.
Choose Contracts:
Once you have determined the market conditions, you need to choose the contracts for your spread. The difference between the contracts will determine the maximum profit and loss of the trade.
Buy and Sell Contracts:
After choosing the contracts, you need to buy and sell contracts of the same type and expiry, but at different strike prices. This will create your futures spread.
Monitor the Trade:
Once you have created your futures spread, you need to monitor the trade. This will help you determine if you need to adjust your position or close the trade.
Advantages of Futures Spread Trading
Futures spread trading offers several advantages to traders, including:
Reduced Risk:
Futures spread trading can reduce risk by hedging against price movements in the cash market.
Lower Margin Requirements:
Futures spread trading can have lower margin requirements than outright futures trading.
Diversification:
Futures spread trading offers traders the ability to diversify their portfolios by gaining exposure to a broad range of assets.
Risks of Futures Spread Trading:
Futures spread trading also comes with risks, including:
Price Volatility:
Futures spread trading is subject to price volatility, which means that the price of the underlying asset can fluctuate rapidly and unpredictably. This can lead to significant gains or losses for traders.
Counterparty Risk:
Futures spread trading is traded on futures exchanges, which act as intermediaries between buyers and sellers. There is a risk that the exchange or the counterparty may default on their obligations.
Conclusion
Futures spread trading is a popular trading strategy that involves taking two positions on a commodity to capitalize on a discrepancy in price. Futures spread trading requires taking two positions simultaneously with different expiration dates to benefit from the price change. The two positions are traded simultaneously as a unit, with each side considered to be a leg of the spread. Trading futures spreads involves determining market conditions, choosing contracts, buying and selling contracts, and monitoring the trade. Futures spread trading offers several advantages to traders, including reduced risk, lower margin requirements, and diversification. However, it also comes with risks, including price volatility and counterparty risk. With this guide, you should be able to understand the basics of futures spread trading and how to use it in trading.
