Spread trading- A futures strategy kept as secret from the public.
Spread trading is nothing but speculation on price difference or opening both buy and sell positions at the same time and then speculate on a profit coming from the price difference between the two contracts or two different commodities. In trading terminology, they are called legs. Buying a spread (bull spread) would result in profit from the increase of the price difference between the two spread legs and selling a spread (bear spread) vice versa. Such a price difference gets displayed in specific spread charts. These charts do not include prices of the individual legs but they only show their price difference.
Types of Commodity Spreads
Interdelivery (Calendar) spread consists of long and short futures positions of the same underlying, but with different expiration months.Intermarket spread is constructed of long and short futures positions of the same underlying traded on two different exchanges. It is of course also possible to combine different expiration months.
Intercommodity spread consists of long and short positions of different commodities. Also in this type of spread, it is possible to combine different expiration months.
Intracrop spread. This spread consists of futures positions of two different commodities within the same harvest period. Applicable mostly for agriculture commodities.
Bull Futures Spread
A Bull Futures Spread is making long with Near month and short with Next month in the same market. Let’s say it is February of 2018. You buy March 2018 Soyabean-NCDEX and sell April 2018 Soyabean-NCDEX. You are long the Near month and short the Next month (March is closer to us than April). It is important to note that the Near month futures contracts tend to move faster than the back months. If Soyabean-NCDEX is on a bull market, March (Near month) should go up faster than April (Next month). That is why this strategy is called Bull Futures Spreads. Since the front months tend to outperform the Next month, a trader who is bullish on Soyabean-NCDEX would buy the Near month, sell the Next month.
This relationship between the Near and Next months is not always true 100% of the time, but it is the majority of the time. That is why when you are long the near month and short the deferred, it is called bull futures spread. The spread should go in your favor on uptrend.
Bear Futures Spread
A Bear Futures Spread is short the Near month and long the Next month. This is the opposite to our Bull Futures Spread. Again, let’s say it is February of 2018. You sell March 2018 Cotton-MCX and buy April 2018 Cotton-MCX. You are short on Near month and long on the Next month. This is a bear spread because the Near month to move faster than the Next month. If Cotton is in a bear market, March (Near month) should go down faster than April (Next month).
Spread Trading Margins
Margins for individual contracts may be reduced when they are part of a spread. The margin for a single contract of cotton is 7%. However, if you are long and short in the same crop year, the margin is only 4%.
The exchanges reduced the margins because the volatility of the spreads is typically lower than the actual contracts. Futures spread slows down the market for the trader. If there is a major external market event like the economy crashes, change in interest rates, a war breaks out, or a foreign country defaults on its bonds, both contracts should be affected equally. It is this type of protection from the systemic risk that allows the exchange to lower the margins for spread trading.
Spread Pricing
Spreads are priced as the difference between the two contracts. If March Soyabean-NCDEX is trading @3400/Quintal (leg1), and April is @ 3500/Quintal (leg2), the spread price is leg2-leg1=100. Tick Values are the same for spreads as they are for individual contracts. If the spread between March Soyabean-NCDEX and April Soyabean-NCDEX is 100 rupees, and the spread moves to 150 rupees, that is 50 rupees move per quintal. 1 rupee in Soyabean-NCDEX is Rs.100 for all months and spreads in the standard 10MT contract. The tick values are the same for spreads as they are for their individual contracts.
Advantages of Spread Trading
Spreads can considerably reduce the risk in trading compared with naked futures trading. Every spread is a hedge. Trading the difference between two contracts in any type of spread results in much lower risk to the trader.
Spreads on futures normally require lower margins than any other form of trading. The result is much greater efficiency in the use of your capital. It is not unusual to be able to trade 5 spreads putting up the same amount of margin as required for 1 outright futures position.
Spread trades are less volatile than other forms of trading. They are considerably less volatile than share trading, options trading, or straight futures trading. In fact, it is because of such low volatility that margins for spreads are so low.
Spreads avoid problems associated with a lack of liquidity. You can trade in less liquid markets.
There is less concern with slippage. Spreads require less precise entries. Getting an exact fill becomes less important. Sadly, the whole truth of the benefits of spread trading has been kept secret from the public.
Spreads in certain situations offer greater odds of winning, but never greater probabilities of losing.