by Don Wellenreiter
Why trade spreads when just being long or short an outright futures contract can be so much more profitable? They can be, but the risk is also much larger. For example, let’s say a trader purchased one July soybean contract at the close on June 9th and sold it on the close on June 13th, and made approximately 60 cents (or $3,000), on a margin requirement of about $1,800. Had the trader purchased the July beans and sold the November beans as a spread, his profit would have been 49 cents (or $2,450), but this is a margin of only $1,100. His return on margin on his outright futures was 166%, but the return on margin for this spread was an even more impressive 222%! And with less risk!
In cases where the trader was wrong about a market’s direction, the benefits of spreading are even more obvious. If the trader believed that Dec wheat was a good buy near the end of June and bought it at $3.49 with a ten cent stop he would have been stopped out of his trade within ten days for his full ten cent loss ($500). However, had he gone long the Dec wheat and short the March wheat spread his loss would have only been 1 ½ cents or $75. This is why the longest lasting traders on the floor of the exchanges are the ones who do spreads. They understand the risk and reward, and they choose to use spreads. If some of the most successful traders use this type of trading method, shouldn’t you at least consider them as part of your trading strategy?
Volatility is another reason to consider spreads. In markets than can be explosive, such as the coffee market, there are enormous opportunities – but also enormous risks. Spreads offer an alternative to an outright position, even to an options position, as options in a volatile market tend to be very expensive. Using coffee as an example, when it approached multi-year highs both the calls and the puts became extremely expensive and taking an outright position was very dangerous. A trader who wanted to be in this market during this volatile time should have looked for a spread position to reduce his risk.
Another reason to trade spreads is the lower margin requirement. This aids the trader in his ability to diversify in other commodities, or to scale trade into the spread. Lower margin requirements can be a two-edged sword. Just because a wheat spread is 1/5th the margin of an outright futures, it doesn’t mean the trader should now do 5 spreads. As in any trading, the trader must use proper risk and money management when entering into a trade.
Special Considerations and Risks
While spreads are often viewed as a less risky trading vehicle than an outright position, this is not always true. When trading inter-commodity or inter-market spreads, the trader needs to be aware of the differences in the commodities and/or the exchanges. He needs to be aware of new crop/old crop relations, especially when they involve two different crop years. Such as in the pork belly market, bellies in storage can not be delivered in the next year crop.
Avoid trading in markets that you are unfamiliar with, or those with little liquidity to them. Also, stay away from contracts that are close to expiration as their volatility can be extremely dangerous. Contracts near expiration do not have daily limits that the other contracts are subject to. An example of this would be if a trader went into a July/November soybean spread near the end of June. This first notice day for July beans is June 30. The trader would be faced with the July contract that doesn’t have a daily limit and the November with a limit of 30 cents.
Always enter and exit your positions as spreads. Legging into or out of a spread can greatly increase your risk and possibly turn a profitable spread into a loss.
Do not put on a spread just to protect a losing position, i.e. you are short the September bond and the market rallies, so instead of taking your loss you buy the Dec bond. You are probably just putting off the pain.
Because different contract months don’t always trade at the same time during the trading day, it can be difficult to get accurate quotes. An example of this would be in a Kansas City Value Line Index vs. the S&P spread. The S&P trades much more frequently during the day than the Value Line Index does. This makes intra-day quotes less than reliable. The best way to judge a spread is by using the closing prices.
Always be aware of the contract specifications of the spread. For example, while Live Cattle has a contract size of 40,000 lbs, the Feeder Cattle contract is for 50,000 lbs. To calculate the spread difference you must first calculate the equity value of each contract then subtract the two to get the difference.