Most traders are familiar with taking basic long and short positions. In either case, you’re making a single bet about the direction of an asset’s price. For futures traders, that bet comes with a deadline in the form of contract expiration.
Yet there’s another way to play futures that minimizes the risk associated with single direction strategies: trading spreads.
To help you understand how to execute this strategy, you’ll find all the fundamentals outlined below in our futures spread trading guide.
What is Futures Spread Trading?
A futures spread can be simply defined as taking a long and short position at the same time. This strategy allows traders to benefit from price discrepancies or inefficiencies and lower risk.
In other words, instead of betting that the price of an asset will go up or down by a certain date, traders can bet both ways – and still make a profit if the price of the asset moves in the right direction.
In this way, spread trades are a hedge and an arbitrage.
How to Trade Futures Spreads?
The core objective of trading a futures spread is to profit from a difference between the price of two simultaneously held contracts, one long and one short.
Futures Spreads Example:
A trader believes there will be a glut of wheat on the market in an upcoming month, which will lower the price of wheat in future months. To capture the spread and benefit from this price shift,the trader simply sells a wheat contract for the earlier month and buys a wheat contract for the future month, after the glut negatively impacts wheat prices. If the price action follows as expected, the trader wins.
While this spread may not return as much profit as a single directional trade, it has the advantage of lowering the risk of making a one-way bet on price action.
What Are Different Types of Futures Spreads?
There are three types of futures spreads: Intermarket, Intramarket and Commodity Product.
Intermarket spreads involve multiple commodities. For example, a trader may long corn and short soybeans.
Intramarket spreads allow traders to choose different monthly expirations for a single commodity, such as corn – a tactic also known as a calendar spread.
Commodity Product spreads replicate the underlying business process of selling a commodity by taking it from its raw form to a finished, market-ready product. Traders take a long position in a raw commodity that must be refined before it is sold (such as oil), and a short position in the finished version of that commodity.
Understanding Futures Spread Margins
In the case of futures spread trading, it is important to understand that margins are generally lower than those seen with conventional futures. The same amount of margin may allow you to trade 10 spreads for every single futures contract, making your capital much more efficient.
The reason for this is because the nature of the spread acts as a hedge against risk and is less affected by volatility. If the markets are rattled by an unexpected event, the gain of the short side mitigates the loss of the long position.
What Are Some Common Futures Spreads?
There are basic futures spread trading strategies that have proved enduringly popular. Because they are tried-and-true, they are a good starting point for less experienced traders.
Some of these strategies include:
Corn and soybeans (an Intermarket spread)
Crude oil and petroleum (an example of the Commodity Product spread mentioned above)
Soybeans and soybean oil, or the “Soybean Crush” (Commodity Product)
Natural gas and electricity (Commodity Product)
July and December corn (an Intramarket spread)
Treasury notes (2-year vs 5-year).
Gold vs. Silver
Reasons to Spread Trade
Spread trading futures offers several powerful benefits. First, futures spreads are more balanced than a single contract, which means they limit risk and provide additional routes to profitability, rather than merely betting an asset will move in a single direction.
Crucially, this strategy provides robust protection against market-wide risk, which is often impossible for traders to anticipate. If a “black swan” event occurs that creates systemic market risk, futures spreads offer protection relative to a long position.
Next, margin requirements are lower, which can generate much higher returns on a winning position.
Spreads are also less susceptible to the actions of market makers or market movers, allowing traders to make a purer play on an underlying trend.
Finally, price movements are easier to predict when futures spread trading, as you can expand your timeline, and are not captive to the more volatile movement of a shorter-dated contract.
Risks to Keep in Mind for Futures Spread Trading
Many of the risks associated with spread trading futures are the same risks that are attached to any trading activity.
Traders should avoid going too deep on margin or trading positions that are too large for them to comfortably absorb losses.
It’s important that traders have the discipline to manage personal trading risk, especially early on. Even though spreads are theoretically safer than taking a long or short position in isolation, if the market moves against you and your trades are excessively large, you can lose substantial capital.
Traders also need to monitor liquidity, as it may be difficult to exit a trade at an attractive price if there is insufficient interest among potential buyers.
Another risk is a failure to understand the broader mechanics of the market.Understanding key concepts, such as backwardation or contango, can help provide traders with the context they need to understand the broader market and avoid making unforced errors.
Markets are in contango when the value of the forward contract is higher than its spot price. Or, the price of a contract expiring in an earlier month is lower than the price of a contract expiring in a later month. This is understood to be a normal market.
A market is in backwardation if the value of the forward contract is lower than the spot price. Or, the price of a contract expiring in an earlier month is higher than the price of a contract expiring in a later month. This is an inverted market and often occurs in bull markets with increased demand or shortages for commodities.
By being able to assess concepts such as these, traders can make more informed individual trading strategies.
How Can RJO Futures Help With Futures Spread Trading?
Now that you’ve read our future spread trading complete guide, we’d like you to learn more about the subject by reaching out directly or by downloading our Intro to Spread Trading Guide.
RJO Futures is a leader in futures trading and one of the most trusted and established names in the business.
We offer traders access to an unparalleled combination of cutting-edge trading tools, educational resources and personal guidance from futures trading experts.
Contact us today for more information about how we can help you start trading futures spreads or options spreads in the most informed manner possible.