Spread Trading - Probably the safest way to invest in Futures

Spread trading in futures is as old as hills, but for many investors, this might be the first time reading about it.

It’s better to be late than never, it’s worth spending time on.

And this introductory article demonstrates "how spread trading might be the safest way to invest in futures".

Warren Buffett Trading Quotes

What is Spread Trading?

A spread trade (either with options or any another financial instrument) involves taking two or more positions (considered as a single position) by the trader.

(Options are financial contracts that give the buyer the right to buy or sell an asset before a specific date or at a specific price)

For example, buying and selling two stocks simultaneously that trade in a similar fashion, or in commodities, you could long (buying position) "corn" and short (selling position) "soybeans".

What is Futures Spread?

Futures spread is an arbitrage technique where the trader takes two positions on a commodity, to profit from the price discrepancy.

The trader completes a ‘unit trade’ with a position to buy and a position to sell.

This simultaneous purchase of one security and the sale of a related security as a unit is called ‘legs’ in finance.

"Options" (put options and call options) and "futures contracts" are the most popular tools for spread trading.

Spread as a Hedge

When you long a "physical vehicle" and short "futures", it is called a ‘hedge’. In fact, it was the main reason "futures markets" were created.

Also, the term "hedging" can be referred to any risk management technique.

For instance "options spread" is a hedging strategy which is conservative. Here the trader sacrifices the upside potential to reduce exposure to risk.

Sometimes, investing terminology can be confusing.

For instance, often times investors confuse "spread trading" with "spread betting" or about "bond spread".

All three inhabit disparate mechanisms.

However, to make things simples, spread in the figurative and literal sense means the same thing.

Let’s briefly discuss two ‘spreads’ to clear the difference before dealing with the mechanics of spread trading.

  • 1. What is Spread Betting?

    Spread Betting is gambling on non-regulated markets.

    The spread and the prices (the bid and the ask) come from the gambling office for spread betting, not from a real market.

    Spread betting has nothing to do with spread trading.

    In fact, in some countries (such as US, Japan, and Australia) spread betting is banned due to its shady nature.

    On the same note, Spread Betting and CFD (contract for difference) are different, the latter is derivative trading that involves speculating the price movement of financial securities.

  • 2. What is Bond Spread?

    A bond spread - also known as the yield spread - is the difference between bond yields (or other debt instruments).

    This difference in bonds could be in terms of the maturity date, expiration date, risk, credit ratings, etc.

    Bond investors use yield spread to gage the profitability of a bond, but that doesn’t necessarily qualify as spread trading.

How Spread Trading Works?

Let’s understand the rudimentary mechanics of spread trading before moving on to advanced strategies.

Imagine two assets (commodities, futures, stocks etc.) A and B, trading for €5 and €4 respectively.

The difference between their current market prices is 5 - 4 = 1, a.k.a. the Spread.

If the market dips by €1, both the assets move down by €1.

So, assets A and B will have new prices of €4 and €3 respectively. However, the spread still stands at €1.

In other words, the trader wouldn’t have lost anything on the spread position.

Spread Example

Now, let’s analyze the spreads by including external factors.

Spread Example

The orange increasing line represents external data.

This external factor could be anything; GDP, price moves, number of producers or anything that could impact the spread.

In our example, we have assumed that the spread at Time 1 was caused by such external factor.

Spread trading is little different from conventional trading.

The most notable difference is that the investor in normal trades keeps an eye on “how the market affects the security price”.

In spread trading, the concern is not the Price, but the Spread.

Since spread is not affected by general market movement (as opposed to price movement), it is more predictable.

Hence, Spreads are a better fit for mathematical models.

A spread can be trending (moving in one direction), mean reverting (moving away from the mean and returning) or have no direction (random distribution).

You can use different testing models such as "Engle-Granger" or "Johansen Cointegration" to tell if a spread is trending, mean reverting or has no direction.

We at SAMT AG use our own Hypothesis testing and analytics to find the direction of a spread.

Is Spread Trading profitable?

Yes. If you understand the market moves (especially of the assets that you want to take a position in), spread trading can be lucrative.

Say, you want to spread trade by buying "cooking oil" and selling "crude oil". To earn a profit you must understand the seasonal fluctuations in their demand.

As a general rule, when you take a position between two assets they should be trading at similar prices. However, this spread needs to narrow or widen in the near future.

The investor profits with the widening or narrowing of the spread.

And this is where market knowledge comes in.

Professionals are better at reading the market.

Say, they might take a position due to wrong accrual policy at Enron by going long RWE in short Enron spread.

They might also see an opportunity between BMW and Tesla, or even some startups with non-GAAP compliant bookkeeping.

The same goes for commodities; a spread opportunity might be present due to natural circumstances or the harvest season.

Let's understand "How Spread Trading can be Profitable?".

Spread Trading Example

Futures contracts A and B are bought and sold at the same time for the price of €100.

Bear in mind that the absolute amount is adjusted to the buy price or the sell price; if A is trading for €5 then 20 futures are bought for €100. And if B is trading at 4€ then 25 futures are sold for €100.

Scenario 1

At Time, T = 1

Account holds €200

Bought 20 A €5 each = €100 long invested

Sold 25 B for €4 each = €100 short invested

At Time, T = 2

Sold 20 A for €6 each = €120 (profit of €20)

Bought 25 B for €2 each = €50 (profit of €50)

With a total profit of €20 + €50 = €70

Scenario 2

Let’s assume that the market goes down and both assets drop in value.

Spread Trading Example

At Time, T = 1

Account holds €200

Bought 20 A €5 each = €100 long invested

Sold 25 B for €4 each = €100 short invested

At Time, T = 2

Sold 20 A for €4 each = €80 (€20 loss)

Bought 25 B for €2 each = €50 (€50 profit)

Total profit of €30

(Note: If Asset A goes down more than Asset B we would lose money)

Scenario 3

Let’s see what happens when both assets go up.

Spread Trading Example

At Time, T = 1

Account holds €200

Bought 20 A €5 each = €100 long invested

Sold 25 B for €4 each = €100 short invested

At Time, T = 2

Sold 20 A for €7 each = €140 (€40 profit)

Bought 25 B for €5 each = €125 (€25 loss)

Total profit of €15

(Note: If Asset A goes down more than Asset B we would lose money)

Scenario 4

And finally, let’s see what happens when assets move in the opposite direction.

Spread Trading Example

At Time, T = 1

Account holds €200

Bought 20 A €5 each = €100 long invested

Sold 25 B for €4 each = €100 short invested

At Time, T = 2

Sold 20 A for €4 each = €80 (€20 loss)

Bought 25 B for €5 each = €125 (€25 loss)

Total loss of €45

In all four scenarios, we’ve seen how unlikely it is to lose money by spread trading on futures.

If we had chosen the conventional way of buying a security the risk would’ve increased manifolds.

However, the investor must know the market thoroughly before taking positions. There’s no alternative to market knowledge!

We are a Swiss registered Wealth Manager and we can help you to manage your money with scientific concepts.

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