Introduction to Futures Spread Trading

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Most new traders to the futures arena, as well as many veteran traders, never become involved with trading spreads. Perhaps it is an intimidation factor, as spreads certainly sound more complicated than trading just an outright long or short position. In fact they are more complicated, but even a novice trader can easily grasp the concept of trading spreads with a little reading and a little work. No pain, no gain as they say, and spreads can certainly be a part of a successful trading program.

What exactly is a spread? It is no more than going long one contract and going short a different but related contract. A popular inter-market spread would be a long wheat/short corn position. The contracts are different, but they are related (corn and wheat are both grains that can be substituted for one another in certain case – e.g. Animal feed). An example of an intra-commodity or calendar spread would be long Nov Orange Juice/short July Orange Juice.

What is interesting about a spread trader is that he does not care whether his contracts go up or down in price, only that the difference in price between the 2 contracts changes in his favor. Let us assume that a spread trader put on the long wheat/short corn spread mentioned above. The objective is for wheat to gain in price on corn. This can happen even if both contracts go down, as long as the price of corn falls further. One can also profit if both contracts rise, as long as wheat rises further in price. Of course there is always the holy grail of spread trading, where one’s long position rises and the short position falls.

Why should the novice trader learn about spreads? A very simple reason might be that professionals trade spreads, and they tend be more successful than your average small speculator. Some other very good reasons are that:

1. Spreads can allow a trader to better manage his risk – many spreads have theoretical floors in their value due to the nature of the market traded, especially carry markets such as the wheat, corn, soybean, and energy markets. Also, many spreads, although not all, can be less volatile than outright positions.
2. Many spreads tend to trend more reliably than an outright position, in general.
3. The seasonal aspects of many spreads can be quite strong.
4. When a market locks limit-up or down, an outright trader can be trapped whereas a spread trader may still be able to close out his position.

Of course, spread trading also has a few caveats. In many cases spreads still cannot be traded on electronic platforms, and spread orders must be sent to the pits. As we all know this can lead to missed fills and delays in fill reports compared to electronic trading, especially in fast markets. Also one needs to be aware that not all spreads are highly liquid, so at times market orders can be risky.