Futures – In Futures Spread Trading the trader simultaneously buys (longs) and sells (shorts) futures contracts for two related commodities or securities. The rationale behind this kind of strategy is that as futures contracts approach maturity, prices of different contacts will often change differently over time, leaving savvy traders an opportunity to profit. We explain this in more detail below, but overall spread trading offers good traders the opportunity to profit off contract spreads instead of taking a position on the market’s direction.
Some traders may also pursue this kind of trade, believing they reduce their overall exposure to the market, since losses from longs will be offset from shorts and vice-versa. Futures spread trading generally is a more conservative approach to trading overall than simply investing in one futures contract.
FX – In FX, spreads traders seek to buy a currency cross in order to take advantage of rollover interest, while simultaneously shorting a similar pair to reduce their exposure to unpredictable fluctuations in price.
Futures – Assume you have two contracts for soybeans: September at $6.50/bushel and November for $5.50/bushel. Assume that in your opening position, you’ve bought (long) 100 bushels from the September contract, and sold (short) 100 bushels of the November contract. The spread is now $1.00, the difference between the two contracts.
|Opened Position||Position After One Week|
|Sept Corn||$ 6.50||$ 6.90|
|Nov Corn||$ (5.50)||$ (5.60)|
|You Paid||$ 1.00||$ 1.30||Earnings|
|30 profit on 100 Bushels|
Let’s say that the September contract goes up to $6.90 while the November contract goes up to $5.60. The spread is now $1.30. You could sell the spread position (short the September contract and long the November contract) and make $0.30 per bushel. In other words, you’ve made a net gain of $40 from buying and then selling the September contracts, while you’ve made a net loss lost $10 from selling and then buying the November contracts. Thus, you’ve made $30 net profit altogether.
However, let’s set up a different scenario where the September contract goes up to $6.60 while the November contract goes up at a faster rate to $5.90. Now the spread is only at $0.70. In this case, although you’ve made a net gain of $10 from the September contract, you’ve also made a net loss of $30 from the November contract. Thus you’re net loss is at $20.
|Opened Position||Position After One Week|
|Sept||$ 6.50||$ 6.60|
|Nov||$ (5.50)||$ (5.90)|
|You Paid||$ 1.00||$ 0.70||Earnings|
|$20 loss on 100 Bushels|
In both cases, both the prices of each contract rose. However, in the above case, there were still net losses. Thus, the rates of growth are more important to gauge in Futures Spread Trading rather than absolute market trends.
Why Opportunities Exist in Futures Spread Trading
Opportunities for spread trading exist for a number of reasons. Spreads may change due to seasonality, backwardation theory and other factors that lead the market to think one contract will be more affected than another for the same commodity. Examples may come from agricultural commodities where harvest month contracts tend to have more supply on the market, pressuring prices down – and from bond markets where contracts that expire before April tend to demand a different price than the same bond contract set to mature after taxes are due.
Inter-commodity and Inter-market spreads tend to trend more than the outright commodity price. Even as commodity prices remain flat, spreads still often trend in one direction. Such consistency in trend is attractive to traders looking for positions that require what they think is less exposure to the market. Lastly because spread positions tend to offset each other, and because they tend to earn brokerages extra commissions for additional positions in the market, brokers will tend to have low margin requirements for spread trades.
FX Example – Let’s try to apply the Spread Trading in Futures to FX markets. In FX we deal in the more efficient spot market. In the Forex market there are no contracts for the same currency pair but different expiration date. Thus spread trading in FX has to work differently. Whereas differences in the price of contracts in the previous example (November vs. September contracts) served as the spread, the spread for this example would be the difference between interest rate yields of currency pairs.
Let’s assume a trader wants to buy 100,000 GBP/JPY because she wants to earn the rollover interest associated with purchasing the Pound against Yen (As of this example the pound earned a 4,75% while the Yen Earned 0.00%). Although she receives the benefits of rollover interest, the trader has exposed herself to 100,000 Pounds and is vulnerable to future exchange rate fluctuations in Sterling or Yen. To counter this risk, the trader decides she wants to create a spread or hedge in the form of a similar short position.
|Market Exposure||Approx Daily Interest|
|Long 100k GBPJPY||100,000 Pounds||+$20-25|
|Short 100 CHFJPY||100,000 Francs or ≈ 42,000 Pounds||-$2-4|
To create a “spread,” the trader would short 100,000 francs – buying CHF/JPY. CHFJPY move similarly to GBP/JPY. From the Chart above you can see the trader earns a hefty rollover while reducing their exposure to Sterling and Yen.
Issues and Disadvantages of This Sort of Strategy
There are some problems associated with trying to create a spread with the currency market however. In futures spread trading, a trader makes equal purchases on similar securities/commodities with different maturity dates. However, in FX you are making purchases on what amounts to completely different underlying assets.
Using the example above, even though the trader has made equal bids on both the GBP/JPY and the CHF/JPY position, she still has not perfectly reduced her exposure to the market. The current exchange rate between the GBP and CHF is at 2.35; a Pound will buy 2.35 Swiss Francs. This means that the 100,000 francs he has shorted in the opening position are only worth approximately 42,000 pounds. Thus, this is an imperfect hedge as the 100,000 francs the trader has shorted to limit his Pounds market exposure are only covered by half. In other words, if she decides not to long 100,000 francs in the next round, the trader is still only covering 42,000 out of the 100,000 Pounds he has purchased.
Now, let’s assume the trader did create a position equal to the GBPJPY with the CHFJPY position. This would mean that she longs 100,000 Pounds in GBPJPY and shorts approximately 240,000 Francs in CHFJPY. Here she has synthetically created a 100,000 GBP/CHF position. But since those positions were opened through JPY pairs the trader would have paid extra spread to open the position. When compared to a straight GBP/CHF trade the traders has paid the spread on the GBPJPY and the CHFJPY position – for essentially the same position.
Traders are at a loss to find a perfect hedging or spread play.
Many traders set up hedged positions or triangular cross spread positions in the belief that they have found a way to achieve interest rate arbitrage while mitigating exposure to foreign exchange fluctuations. However traders should take the short time required to check the mathematical rationale behind their trade. Often there is a more direct trade they can make that saves added spread – although it probably won’t look quite as impressive in the open positions window.