The trading world is full of various strategies and methods for making a potential profit. Arbitrage trading is one of the most efficient, yet at the same time, also one of the most complicated strategies. Many traders prefer Futures spread trading as an arbitrage strategy. They consider it one of the safer ways to try and profit from the commodity market. In this guide, we will help you find out more about the most popular futures spread trading strategies and how to use them. We will also examine different futures spread trading examples along with their pros and cons. Let’s go!
What is a Futures Spread?
Futures spread is a trading technique where you open a long and a short position simultaneously to take advantage of a price discrepancy.
The idea behind futures spread trading strategies is to reduce the risk. At the same time, it allows you to capitalize on the pricing inefficiencies for one or several instruments. You can use spreads for a variety of asset classes. In this article, we will focus on using it with futures trading and commodities, in particular.
A while ago, due to the market’s structure, spread trading strategies were available only to institutional and large-scale traders. However, today, they are gaining popularity among retail traders, as well. This is thanks to technological development and a reduction in the margin requirements. Furthermore, these futures spreads are gaining popularity among retail traders, as well.
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Understanding How Futures Spreads Work
The objective of futures spread trading strategies is to capture the difference between the price of the contract that is being sold and the one that is bought. This usually works when trading futures with different expiration dates. One example of a futures spread is when you go long and short on a soybeans futures contract (ZS) at the same time. You can also apply it to different types of assets like soybean and corn, for example.
The buy and sell positions that the trader opens at the same time are acknowledged as a single position, called a “unit trade”. The buy and the sell sides of the unit trade are called “legs”.
The goal of the trader placing the unit trade is to see the long side of the spread increase compared to the short one. That way, the spread between their positions guarantees they capture a more significant profit.
Types of Futures Spreads
Depending on the trader’s preferences about the type of commodity they want to focus on, its state, and the exact strategy of how to trade it, they can choose from three types of futures spreads. These are inter-commodity, intra-commodity, and commodity product spreads.
Aside from these, although rarely, you can also hear experts talk about bull and bear futures spreads. Now let us take a look at the difference between the two. With bull futures spreads, the trader goes long on the front month and shorts the deferred one. Meanwhile, in bear futures spreads, he goes long on the deferred month and shorts the front month.
Now back to the main types. The common categories are typically inter-commodity, intra-commodity, and product spreads. Let’s find out how are they different from each other:
Inter-commodity futures spreads
An inter-commodity futures spread is the type where contracts on various commodities with the same month are utilized. For example, when you simultaneously open positions to buy corn futures (ZC) and sell wheat futures (ZW), both of which expire in September.
For those interested in inter-commodity futures spreads, it is essential to be aware of the specifics and the price drivers of the instruments they intend to trade. This means having expertise in trading various futures contracts, which usually isn’t typical for beginners in the field.
Intra-commodity futures spreads
Intra-commodity futures spread trading is used when the trader buys and sells the same commodity but with different months. For example, the trader may buy an April soybean futures contract and sell an October soybean futures contract. In this case, the “legs” of the trade spread are between different months, rather than other instruments.
This type of futures spreads is also known as “calendar spreads”.
Calendar spreads are considered easier to trade since the trader only needs to specialize in a single commodity. By learning all about different price factors like seasonality, supply, and demand, weather conditions, etc., they can ensure they have the fundamentals to trade that particular commodity.
Commodity product spreads
The commodity product spreads reflect the difference in the commodity’s price in its raw form and as a finished product.
Commodity product spreads are a frequent choice for traders interested in the oil and agriculture industries. Traders usually enjoy this type of commodity product spread and trade them by going long on the raw material and shorting the finished product related to it. That way, the profit basically replicates the profit margin of the company that handles the whole process.
Bear in mind that this type of futures spread is usually more of an exotic instrument.
Futures Spreads Margin
Margin requirements are a crucial thing that any trader interested in futures spread trading should be aware of. They indicate the level of volatility and risk associated with the underlying commodity or the relationship between the traded assets (if more than one).
Futures spreads margins are lower than those of traditional futures contracts since they bear less volatility and hedge against systemic risk. In the case of an unexpected event like a terrorist attack, a stock market crash, a war breaking out, or the 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.
Example
Assume that Joe wants to trade corn and wheat futures spreads. Let’s 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 to trade the spread on the two contracts, Joe can receive a 75% margin credit. This means the initial margin will equal just $750.
What this comes to show is the massive difference in terms of the margin requirement when trading single contracts outright 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 you should comply with when trading futures spreads.
Common Futures Spreads
Depending on their type, there are a variety of widely-used futures spreads. Such pairs include:
- July corn and December corn
- Soybean and corn
- Kansas City Wheat and Chicago Wheat
- Natural gas (raw material) and electricity (finished product)
- Crude oil (raw material) and petroleum products (finished product)
- Soybean (raw material) and soybean oil (finished product)
- Fed Funds and Eurodollars
- 2-Year T-Note and 5-Year T-Note
The list goes on and on. The idea here is that traders shape their preferences depending on the type of spread they trade, the specifics of the underlying asset, and what factors might affect the spread.
A Closer Look at Specific Assets
In the case of crude oil or natural gas, traders base their analysis mostly on the seasonality effect. For example, during the winter, the need for heating and energy consumption increases, which drives the demand for natural gas. During the summer, on the other hand, the demand for petroleum goes up as the traffic increases. The consequence is a positive effect on the price of crude oil.
It is the same case with crops. Depending on the harvesting period, the weather conditions, the supply and demand figures, whether farmers’ lean towards one or the other seed, and other similar factors, traders may shift their preferences for particular commodities. These are some of the factors relevant to those willing to trade the Soybean – Corn spread, for example.
In the case of futures spreads based on financial instruments, the most widely considered factors include interest rate changes, national policies, global economic and political landscape, etc.
In the end, no matter what spread you are trading, make sure to put your 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 downwards markets as well.
How To Trade Futures Spreads
Although less risky than buying and selling single futures contracts, trading futures spreads still requires substantial expertise and attention to detail. In the cases where inter-commodity futures spreads are traded, for example, the trader should be aware of the specifics of different instruments.
The first step to becoming a successful futures spreads trader is to get familiar with the primary factors and characteristics of the different commodities or instruments that you are willing to trade. Here are some of those factors:
Seasonality
First and foremost, consider the time of the year. You need to know how it may affect the price of the instruments you are willing to trade. Seasonal factors are among the detrimental ones for the instruments’ price. It is a real risk whether you are buying or selling single futures contracts or trading futures spreads.
The reason is that seasonality determines supply and demand. Some commodities like natural gas, for example, may be in higher demand during the winter, while others like crude oil during the summer. On the other hand, a warm winter can reduce the demand for gas and heating oil, thus decreasing their price.
The case is similar when it comes to trading grains futures, the prices of which depend on the harvest period’s results. Weather conditions also have a direct effect on these. If we take corn, for example, we can say that it has the largest supply in the fall, which may decrease its price during that particular period. The majority of the grains usually hit their highest price in the late spring and early summer, when they are most vulnerable to extreme weather conditions. That is why, depending on the year and the weather forecasts, you can expect a so-called “weather premium” to affect the price of the grains.
The easiest way to overcome the seasonality effect is to analyze the spreads’ performance over the years and see over which time periods they perform the best.
The political situation and macroeconomic conditions
It is essential to not only focus on the specific characteristics of the commodity but also to keep an eye on the macro factors that may affect your spreads. These include trade wars, embargos, global political instabilities, interest rates policy, financial and economic crises, region-specific developments, etc.
This is crucial for all types of futures spreads, but most importantly, inter-commodity and product spreads. In the case of intra-commodity spreads, although there would be some difference, the overall effect should equally affect both legs of the trade. For example, if you are trading April and August crude oil and some instability in the Middle-East region arises, then the spread between the buy and the sell order should remain the same.
Stay informed about the industries
Financial and commodity markets are very dynamic. Things 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 you are interested in.
The best way to do that is by accompanying your morning coffee with an official industry analysis or report. Good places to start, depending on the futures spread contracts you are interested in trading are:
- For financial futures spreads, all related official economic reports, and interest rates bulletins.
- In the case of cattle futures spreads, the official reports from the United States Department of Agriculture (USDA).
- For grains like corn or others, the WASDE Report, the Planting Intentions Report, the Crop Production report, and the Grain Stocks Report from the National Agricultural Statistics Services (NASS), and all reports from the U.S. Grains Council. You can also keep an eye on the Global Drought Monitor.
- For crude oil futures spreads, the weekly reports from the Energy Information Administration (EIA) and the weekly statistical analysis from the American Petroleum Institute (API).
Of course, there are plenty of other sources, but you get the idea. Stay on top of the most recent news to increase your profit potential.
Strategies For Trading Futures Spreads
There are a variety of futures spreads trading strategies that you can use. Here, we will go through some of the most basic and the most popular ones. We will also learn how to apply them in practice. Remember not to just blindly follow these strategies. Use your own best judgment when trying them.
Gold Bull Spread
This intra-market spreads strategy requires buying and selling a single contract but with different expiration months. The goal here is to benefit from short-term price increases.
Here is how this works in practice. Let’s assume that you have an interest in trading the soybeans futures (ZS) in a spread strategy. To do that, you can:
- Start by buying November 2020 soybean futures (ZS) for $874.4.
- At the same time, you should also sell one ZS futures contract. Let’s assume you are selling March 2021 ZS for $885.0.
- In the meantime, you follow the news and read reports to keep track of the factors that may potentially affect the price of the commodity.
- If the contract’s price for the front month rises quicker than the one of the contract for the deferred month, you will profit.
The end goal here is to see the spread narrow. During bull markets, this happens when you go long on nearer contracts and short the far-term ones as they are slower to react to price changes.
Gold Bear Spread
Understandably, the bear-market alternative of the strategy mentioned above works the opposite way. You should expect the price of the nearer month contract to fall faster and farther than the price of the deferred one during bear markets. This strategy aims to take advantage of widening spreads.
Examples of Trading Futures Spreads
Example 1
Let’s say that you have an interest in creating a unit trade by buying an August (front month) wheat futures contract for $5.25 per bushel and selling an October (deferred month) wheat contract for $5.65 per bushel. The way to calculate the spread is by subtracting the deferred month from the front one ($5.25 – $5.65 = -$0.4). In this case, it is 40 cents. As the front number trades lower than the deferred one, the spread is quoted as negative.
To calculate the profit/loss of the trade, you should multiply the spread by the price change. For example, a 10 cents price change will result in $400 profits/loss.
Example 2
Assume that it is the end of the year, and you are bullish on the soybeans forecasts for next year. Front months usually outperform latter months. Because of that, you buy a March soybeans future for 875.0 and sell a September contract for 883.0. In that case, the spread is calculated as follows: 875.0 – 883.0 = -8. If your forecast turns accurate and the spread has narrowed from -8 to -5 by March, then your profit equals 3 cents. Since one contract is for the delivery of 5 000 bushels, your total profit is $150.
Let’s also take a look at an example of an inter-commodity spread. Let’s say that you have an interest in trading corn and wheat. Your analysis reveals that the demand for corn will exceed the one for wheat. Here we will ignore the price of the contracts and whether they will go up or down. Your only goal here is to see the price of corn advance farther over the one of wheat. If the market sells off, you will hope for the corn to retain its price better than the one of wheat.
Advantages and Disadvantages of Trading Futures Spreads
At first sight, futures spread trading may seem like the safest strategy ever to exist. However, the truth is that, aside from the abundance of advantages, it also has some drawbacks. The list of the former, in particular, can be quite long. To elaborate on both, we will focus on the main pros and cons of trading futures spreads:
Advantages
Better risk/reward than trading single futures contracts
Aside from reducing the risk significantly, futures spreads also provide a variety of ways to make profits. Although controlled and without as much leverage as single contracts, futures spreads are considered a much more balanced instrument.
Price movements are easier to forecast
Futures spreads trading makes it easier to predict how the different contracts (legs of the trade) will react to particular events. During both bear and bull markets, the closer contract’s price is usually more affected than the one of the longer-term contract.
Lower margin requirements
Since futures spreads trading bears less risk, over time, it has led to a major decrease in the margin requirements. That way, the trader gets way better ROI than when trading single futures contracts.
Clients with small portfolios are welcome
A typical stock or futures broker may require you to deposit $5,000 or more to be eligible to trade. With futures spreads, however, things are quite different. Depending on the service provider’s requirements, often you can open an account with just $50.
A good field for beginners to make their first steps
Futures spread trading eliminates systemic risk, which is the most unpredictable and problematic event for beginners and professional traders. This makes them a much better place for newbies to make their first steps, without the fear of losing significant capital.
Disadvantages
More trades = more commissions
The major drawback of futures spreads trading is that each trade consists of two legs, buying and selling an instrument. This basically doubles the trading fees. If you do not take them into account initially when building your strategy, they may eat up a big chunk of your profits.
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 or have to get in and out of positions quickly.
Risks Involved in Trading Futures Spreads
Like any other type of trading activity, the main risk here comes from trading excessively large positions. Even so, you should not take it lightly. Traders who don’t adhere to some basic risk management principles may lose a big part of their portfolio. Especially if they fail to predict the spread’s change correctly.
There is also the risk of locking yourself in a trade due to a lack of liquidity. The relatively lower trading volume in futures spreads may make you struggle to close your position. Especially if, you combine it with situations where traders buy and sell more exotic futures. Your profit may decrease notably if you fall into that trap.
Although not particularly a risk, it is worth mentioning the need to keep an eye on where you place your entry and exit points. It is imperative to adhere to a clear risk management strategy. That way, you will make sure to avoid situations where emotions take over. It will help you avoid throwing your plan in the bin in pursuit of higher profits. As you know, this usually doesn’t end well.
