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Understanding Futures Spreads
Spreading, a trade in which you simultaneously buy one futures contract and sell another, is a popular strategy among many different asset classes.
One reason they are popular is because they can be less risky when compared to outright futures. And because they are less risky, they also tend to have lower margin requirements.
In this lesson, we will look at the various types of spread trades, including the features that make them valuable strategies for both hedgers and speculators alike.
Types of Spreads
Spreads can be categorized in three ways: intramarket spreads, intermarket spreads, and Commodity Product spreads.
Participants who use these strategies are more concerned with the relationship between the legs of the spread than the actual prices or direction of the market.
Intramarket spreads, also referred to as calendar spreads, involve buying a futures contract in one month while simultaneously selling the same contract in a different month.
One example would be the buying the March 2018 Eurodollar futures contract and selling the March 2021 Eurodollar futures contract.
Calendar spread traders are primarily focused on changes in the relationship between the two contract months; the goal of this strategy is to take advantage of those changes. In most cases, there will be a loss in one leg of the spread, but a profit in the other leg. If the calendar spread is successful, the gain in the profitable leg will outweigh the loss in the losing leg.
Calendar spreads are also used by hedgers to roll a futures position from one month to the next.
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.
For example, the Gold-Silver Ratio spread is a tool for trading on the relationship between Gold and Silver futures prices. This spread can be viewed as an indicator of the health of the global macro economy.
Market participants can express their views on the economy or the relationship between these two products with this spread.
COMMODITY PRODUCT SPREADS
Commodity product spreads involve buying and selling futures contracts that are related in the processing of raw commodities. For example, the Soybean Crush involves buying Soybean futures and selling Soybean Meal and Soybean Oil futures.
The participants in this spread are able to simulate the financial aspects of soybean processing, that is, buying soybeans, crushing them and selling the resulting soymeal and soybean oil. The Soybean Crush spread allows processors to hedge their price risks, while traders will look at the spread to capitalize on potential profit opportunities.
As previously mentioned, one of the attractions of spread trading is the relatively lower risk versus outright futures positions, and the subsequent lower margins. See how this works with the Soybean-Corn spread.
Assume, the outright margin for Soybean futures is at $3,000 and the outright margin for Corn futures is $1,500.
Rather than posting $4,500 to trade a spread on these two contracts, a trader may receive a 75% margin credit; in other words, the initial margin would be $1,125, which reflects the lower risk in spreading the two contracts as opposed to trading each of them outright.
There are many spread strategies that allow market participants to manage risk and capitalize on potential opportunities.