Trading futures spreads, there are important reasons why spread trading should be considered if you’re looking for an approach to trading futures.
Over my 20+ year career as a commodities broker, I have studied and traded a wide range of approaches to trading the futures markets. From candlestick formations to the commodity channel index, from condors to turtle trading, there’s an enormous catalog of tools and methods available for traders to consider.
One method I have noticed is surprisingly underrepresented among retail traders is futures spread trading, where a single position in the market consists of the simultaneous purchase of one futures contract and sale of a related futures contract as a unit. I call it surprising because some of the most invested players in futures trading – and arguably the most sophisticated – include large speculators and commercial firms who regularly employ spreads. This includes traders in the markets who often actually buy and sell the physical commodities we trade. Farmers, ranchers and other food growers along with food producers, petroleum companies who either drill for oil or natural gas or refine these products – or both, financial institutions with enormous holdings in treasuries, equities or currencies, mining interests and their buyers – all these areas of production and distribution employ spreads from time to time as an important aspect of their businesses. Indeed, spread trading is a fundamental and essential part of the commodities futures markets.
At the same time, despite the remarkable increase in interest and in the growth in the volume of the futures markets over the years, spread trading is typically dismissed by most other traders in search of a trading strategy. With so much attention focused on other approaches related to straightforward directional trading (and within that category, day-trading) it’s not difficult to see how spread trading can be overlooked.
If you like this Article, Please share!Spread trading can also be challenging to figure out anyway. On the surface, buying July soybeans and selling November soybeans, for example, might look like a downright futile endeavor.
But there are some important reasons why spread trading should be considered if you’re looking for an approach to trading futures.
Lower volatility: many futures contracts can be extremely volatile, not just during their U.S. daytime trading hours, but during those nighttime hours when the preferred activity for many traders is sleep – and trading volume can be greatly reduced. Certain types of spreads can greatly reduce volatility risk for futures positions and be a viable substitute for placing stop orders. In this case, a spread might enable you to withstand the “surprises” that often appear when you rise to a new day.
Less margin: because of the lower volatility, the exchanges set margin requirements for many futures spreads that can be much less than an outright futures position. For example, the current initial margin requirement for July soybeans is $4,590. The current total initial margin requirement for the July soybean / November soybean spread mentioned above is $2,700
But, why bother educating one’s self on the inner workings of futures spreads? What advantages come with lower volatility and lower margins? Those qualities by themselves don’t very strongly suggest futures spread trading is worth pursuing. Buying an out-of-the-money futures option for $200, after all, is also low in volatility and risk.
Well, consider this: those same large speculators and commercial firms who regularly employ spreads – again, some of the most invested and arguably the most sophisticated players in futures trading – are often employing spreads based on market conditions and events that recur at periodic intervals.
Maybe the most obvious of these intervals is the cycle of weather from warm to cold and back to warm. For agricultural and energy futures markets, weather – more accurately the seasons – can have an important affect on price movement. For example, enormous supplies of soybeans, once harvested, dwindle throughout the year. The same goes for other agricultural commodities such as wheat, corn, sugar, and cotton.
Seasons and weather changes affect energy prices as well. Demand for heating oil typically rises as cold weather approaches but subsides as refiners meet the anticipated demand. Memorial Day typically marks the beginning of the “driving season” in the United States and similarly, a vast number of the rest of the world’s population prepares to “go on holiday.” As a result, gas consumption rises.
Seasons and weather changes aren’t the only cycles affecting the markets. Cycles in the financial arena can affect related futures markets. Consider how a nation’s fiscal year and tax due date is often at variance with others who are important trading partners. That can influence currency flows and the forces on interest rate-sensitive instruments.
All these forces, though certainly not 100% predictable, give rise to recurring price phenomena - to greater or lesser degree and in a more or less timely manner – and reveal a tendency for prices to move in the same direction at a similar time every year.
Spread trades can take advantage of these types of cycles. Consider this: Market-driven U.S. interest rates historically exhibit a strong tendency to reach a seasonal high around April/May — presumably when monetary liquidity is tightest after the massive transfer of financial assets from out of the private sector and into the public sector – in the form of income tax payments due April 15. At the same time, the long June 10-year Treasury Note / Short June 30-year Treasury Bond spread has closed in favor of the 10-year note between February 8 and April 17 in 17 of the last 19 years!
And how that spread found itself into this article leads me to the heart of the article: where can you find out more information about futures spread trading?
They may be harder to find, but there are some very good sources of research on futures spreads available for your investigation. My personal favorite is Moore Research Center, Inc. (www.mrci.com). They’re responsible for the description and record keeping of the interest rate spread I just cited.
Although spread trading represents an important slice of the overall trading volume in the futures markets – and is used as a strategy by some very sophisticated participants, I see it as an approach worthy of investigation by futures traders more broadly, including most of our readers. Even if spread trading can take on the directional characteristic of straight futures trading, it is certainly an overall different approach and that can be the strategy diversification you’re looking for.
As is always the case when we share trade proposals of this sort, we want to make sure we square up our discussion with the always-important information. Spread trading like all futures trading, isn’t without its risks. Even with regard to the annual cycles referenced above, which will inevitably ebb and flow both daily and longer term – no spread works every time. Just look at how some summers are hotter and dryer - and at more critical times - than others for an example of what can affect a grain, livestock, energy, possibly even another type of spread. Make sure you’re aware of the risks to trading futures spreads as you should with any futures trade.
Disclaimers:
* Please note that the information contained in this letter is intended for clients, prospective clients, and audiences who have a basic understanding, familiarity, and interest in the futures markets.
** The material contained in this letter is of opinion only and does not guarantee any profits. These are risky markets and only risk capital should be used. Past performances are not necessarily indicative of future results.
*** This is not a solicitation of any order to buy or sell, but a current market view provided by Cannon Trading Inc. Any statement of facts herein contained are derived from sources believed to be reliable, but are not guaranteed as to accuracy, nor they purport to be complete. No responsibility is assumed with respect to any such statement or with respect to any expression of opinion herein contained. Readers are urged to exercise their own judgment in trading!
Seasonal tendencies are a composite of some of the more consistent commodities futures seasonals that have occurred over the past 15 years. There are usually underlying fundamental circumstances that occur annually that tend to cause the futures markets to react in a similar directional manner during a certain calendar period of the year. Even if a seasonal tendency occurs in the future, it may not result in a profitable transaction as fees and the timing of the entry and liquidation may impact on the results. No representation is being made that any account has in the past or will in the future achieve profits utilizing these strategies. No representation is being made that that price patterns will recur in the future. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Results not adjusted for commission and slippage.
