Spread trading in futures
Spreads - A whole new way to trade by Joe Ross
What Is a Spread?
Spread trading in futures is as old as the hills, yet it is an entirely new concept for most current traders in futures. In this introductory piece, we will show you that spreads can be the most conservative, safest way to trade in the futures markets. But first, what exactly is a spread?
A spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts. You can turn that around to state that a spread is the purchase of one or more futures contracts and the sale of one or more offsetting futures contracts. A spread is also created when a trader owns (is long) the physical vehicle and offsets by selling (going short) futures.
Furthermore, a spread is defined as the purchase and sale of one or more offsetting futures contracts normally recognized as a spread by the fact that the two sides of the spread are actually related in some way. This explicitly excludes those exotic spreads put forth by some vendors, which are nothing more than computer generated coincidences which are not in any way related. Such exotic spreads as Long Bond futures and Short Bean Oil futures may show up as reliable computer generated spreads, but bean oil and bonds are not really related. Such spreads fall into the same category as believing the annual performance of the U.S. stock market is somehow related to the outcome of the Super Bowl sporting event.
The rationale behind spread trading is one of the best-kept secrets of the insiders of the futures markets. While spreading is commonly done by the market insiders, much effort is made to conceal this technique and all of its benefits from outsiders, you and me. After all, why would the insiders want to give away their edge? By keeping us from knowing about spreading, they retain a distinct advantage. Spreading is one of the most conservative forms of trading. It is much safer than the trading of outright (naked) futures contracts. Lets take a quick look at some of the benefits of using spreads:
1. Intramarket spreads require considerably less margin, typically around 25% - 75% of the margin needed for outright futures positions.
2. Intramarket spreads offer a far greater return on investment than is possible with outright futures positions. Why? Because you are posting less margin for the same amount of possible return.
3. Spreads, in general, trend more often than outright futures.
4. Spreads are often trending when outright futures are flat.
5. Spreads can be filtered by virtue of seasonality, backwardation, and carrying charge differentials, in addition to any other filters you might be using in your trading.
6. Spreads can be used to create partial futures positions. In fact, virtually anything that can be done with options on futures can be accomplished via spread trading.
7. Spreads allow you to take less risk than is available with outright futures positions. The amount of risk between two Intramarket futures positions is usually less than the risk in an outright futures position. The risk between owning the underlying and holding a futures contract involves the least risk of all. Spreads make it possible to hedge any position you might have in the market. Whether you are hedging between physical ownership and futures, or between two futures positions, the risk is lower than that of outright futures. In that sense, every hedge is a spread.
8. Spread order entry enables you to enter or exit a trade using an actual spread order, or by independently entering each side of the spread (legging in/out).
9. Spreads are one of the few ways to obtain decent fills by legging in/out during the market Closing.
10. Live data is not needed for spread trading, saving you $$ in exchange fees.
11. You will not be the victim of stop running when using Intramarket spreads.
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