When you think of trading futures, you probably think of buying and selling one crude oil, gold, or S&P futures contract. But you’re not limited to trading one contract at a time. You can trade two or more contracts at the same time, and in the opposite direction (one “long” and the other “short”). That’s the premise behind futures spread trading.
Why Trade a Futures Spread?
When you trade a single futures contract, you expose yourself to significant risk. One external event can significantly impact a commodity’s price and turn your position into a big loss.
When you trade a futures spread, it’s not so much about which way the price is moving; it’s more about the relative value of the two contracts you’re trading (more on that later).
Futures spread trading has benefits. Here are a few of them.
- You possibly minimize your risk exposure versus trading straight futures contracts.
- Volatility may be lower and as a result, margins may also be lower than trading single contracts.
- Your buying power reduction is smaller than when you trade single futures contracts.
What Is Futures Spread Trading?
It’s when you buy one futures contract and sell another of the same or similar contract. There are two main types of futures spreads—intramarket (or intracommodity) and intermarket (or intercommodity).
Let’s start with intramarket spreads.
What’s an Intramarket Spread?
It’s when you trade two contracts of the same commodity and spread it between different months. This type of spread is often referred to as a calendar spread—a long or short position in one contract month and taking the opposite side in the same commodity but in a different expiration month.
Keep in mind that calendar spreads in futures don’t have the same mechanics as calendar spreads in options trading. They’re different products.
To help understand how intramarket spreads work and why the relationship between the two contracts is important, here’s a few examples of how a sample trade could play out.
You buy a June Gold contract and sell an October Gold contract.
Example Outcome 1:
- June gold contract’s price rises relative to the October contract’s price.
- The spread narrows and you would make a profit.
Example Outcome 2:
- June gold contract’s price falls relative to the October contract’s price. October contract also falls but not as rapidly as the June contract.
- The spread narrows but only slightly and you would make a profit, BUT the profit would be less than Example Outcome 1 above.
Example Outcome 3:
- June gold contract’s price falls, but the October contract’s price rises.
- The spread widens and this trade would result in a loss.
It’s about relationships. A futures spread trader looks to benefit from the relationship between the two contracts. Maybe the short contract has a loss but the long one has a profit. As long as the gain is greater than the loss, the spread is profitable. If the gain is less than the loss, the spread will result in a loss.
You can take a bullish or bearish position with calendar spreads. A bullish spread is when you’re long the near month and short the further month in the same commodity. Usually, the near month contract tends to move more quickly and farther than the further out month. If prices move as expected, you’d have a profit. If prices moved contrary to your expectations though, your spread trade could result in a loss.
A bearish spread is when you’re short the near month and long the further month. Since you’re selling the near month contract you want prices to fall.
Your decision to take a bullish or bearish position could be based on whether the contracts are in “contango” or “backwardation.”
What’s an Intermarket Spread?
It’s the spread between two related commodities. So, you could buy a futures contract in one delivery month and short a contract in a related market with the same delivery month. The correlation between two related commodities may not be as high as between contracts of the same commodity. As a result, intermarket spreads tend to be more volatile than intramarket spreads.
These are many different types of intermarket spreads. Here are a few you may have heard about.
- Crack spread. Energy traders often watch the crack spread, which is the difference between crude oil price and products derived from crude such as gasoline, diesel, or jet fuel.
- Crush spread: This is a trade between soybeans and their byproducts. An example would be when you buy a soybean futures contract and sell a soybean meal contract. In this case, if you want to profit from the spread, you want soybean prices to be higher than soybean meal.
- NOB spread: This is a yield curve ratio that can take advantage of the difference between 10-year Treasury notes and 30-year Treasury bonds. There’s an added layer of complexity in these spreads since you’ll have to normalize the contracts you’re trading. Even if you don’t trade NOB spreads, it’s a good idea to keep an eye on it since it can give an indication of economic conditions.
As with intramarket spreads, intermarket spread profits are based on the relationship between the prices of the two traded contracts.
You can never anticipate events: Major wars could break out, a pandemic could freeze the global economy, natural disasters could impact nations. Futures spread trading can help to reduce risk against external market events. In addition, futures spreads can reduce your leverage and give you the opportunity to gain exposure to commodities using less of your capital than if you traded single futures contracts.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.