GET Financial Education Series - Futures
Spread Strategies – Lesson 15
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Futures traders are not limited to simply buying and selling one Futures contract at a time to take advantage of price movements in the Futures market. They have the ability to buy and sell offsetting contracts in what is known as a 'spread' trade.
Spreads take on various forms but they all have two things in common:
- they provide a hedge against adverse price movement and
- they are designed to take advantage of the changes in price relationships between two Futures contracts.
Spreads provide a hedge against adverse price movement because you simultaneously buy and sell Futures contracts when you enter a hedge. As the value of one contract goes up the value of the other contract goes down. For instance if you incur losses on the Futures contract you bought as part of the spread, you can partially offset them with the gains you will realize on the contract you sold as part of the spread. Conversely if you incur losses on the Futures contract you sold as part of the spread, you can partially offset them with the gains you will realize on the contract you bought as part of the spread.
Spreads take advantage of changes in price relationships. Imagine, for instance, that you see crude oil Futures contracts trading on one exchange for $110 per barrel and crude oil Futures trading on another exchange for $111 per barrel. You could enter a spread trade by buying the crude oil Futures contract that was trading at $110 per barrel and selling the crude oil Futures contract that was trading at $111 per barrel. If the two prices eventually converge, you will make a profit.
In this section we will be focusing on the following three types of spread trades:
- Inter-delivery spreads
- Inter-commodity spreads
- Inter-exchange spreads
Inter-Delivery Spreads
An inter-delivery spread is one in which a trader buys a Futures contract with a certain delivery month and simultaneously sells the same Futures contract with a different delivery month on the same exchange. Here’s the simple breakdown:
| Futures Contract: |
Same |
| Delivery (Expiration) Month: |
Different |
| Exchange: |
Same |
Inter-delivery spreads are also sometimes referred to as 'intra-market spreads' or 'calendar spreads'.
Imagine that you want to buy the July Chicago wheat contract (traded on the Chicago Board of Trade, or CBOT) because you believe prices are going to go up in the short term, but you want to hedge some of your exposure to the down-side. You can accomplish this by buying the July wheat contract and simultaneously selling the September wheat contract. If the price of wheat increases in the short term, the price of the July wheat contract will probably increase faster than the price of the September wheat contract - causing you to make more money on the July contract than you will lose on the September contract. On the other hand if the price of wheat decreases in the short term, the price of the July wheat contract will also probably decrease faster than the price of the September wheat contract - causing you to lose some money on the July contract but enabling you to offset some of your losses with your gains on the September contract.
Traders divide inter-delivery spreads into two categories - 'bull spreads' and 'bear spreads'. A bull spread is an inter-delivery spread where you buy the 'nearby' contract (the contract that will expire the soonest) and sell the 'deferred' contract (the contract that will expire the latest). Trades utilize bull spreads when they believe prices are going to increase in the near-term.
The example above of buying the July wheat contract and selling September's equivalent is an excellent example of a bull spread.
A bear spread is an inter-delivery spread where you sell the nearby contract and buy the deferred contract. Trades utilize bear spreads when they believe prices are going to decrease in the near-term.
The obverse of the example above would be an excellent example of a bear spread.
Imagine you want to sell the July wheat contract because you believe prices are going to go down in the short term but you want to hedge some of your exposure to the up-side. You can accomplish this by selling the July wheat contract and simultaneously buying the September wheat contract. If the price of wheat decreases in the short term then the price of the July wheat contract will probably increase faster than the price of the September wheat contract - causing you to make more money on the July contract than you will lose on the September contract. On the other hand if the price of wheat increases in the short term then the price of the July wheat contract will also probably decrease faster than the price of the September wheat contract - causing you to lose some money on the July contract but allowing you to offset some of those losses by your gains on the September contract.
Inter-Commodity Spreads
An inter-commodity spread is a spread in which a trader buys a Futures contract with a certain delivery month and simultaneously sells a different, but related, Futures contract with the same delivery month on the same exchange. Here’s the simple breakdown:
| Futures Contract: |
Different |
| Delivery (Expiration) Month: |
Same |
| Exchange: |
Same |
Imagine once again you want to buy the July Chicago wheat contract because you believe prices are going to go up in the short term, but you want to hedge some of your exposure to the down-side. However you don't currently see any price advantage in using an inter-delivery spread. Instead you decide to use an inter-commodity spread and hedge the risk you face (as a consequence of buying a July wheat contract) by selling a July Chicago corn contract.
Wheat and corn are two different commodities but they are closely related. Both commodities have relatively similar growing seasons, both are grain, and both are important in the global food supply. Now, however, you believe the price of wheat is going to increase faster than the price of corn. To take advantage of this price discrepancy you decide to buy the July wheat contract and sell the July corn contract. If the price of wheat increases faster in the short term than the price of corn, the price of the July wheat contract will probably increase faster than the price of the July corn contract - enabling you to make more money on the July wheat contract than you will lose on the July corn contract. On the other hand if the price of wheat decreases faster in the short term than the price of corn, the price of the July wheat contract will also probably decrease faster than the price of the July corn contract - causing you to lose some money on the July wheat contract but enabling you to offset some of your losses with your gains on the July corn contract.
Inter-Exchange Spreads
An inter-market spread is a spread in which a trader buys a Futures contract with a certain delivery month and simultaneously sells the same Futures contract with a the same delivery month on a different exchange. Here's the simple breakdown:
| Futures Contract: |
Same |
| Delivery (Expiration) Month: |
Same |
| Exchange: |
Different |
Inter-exchange spreads are also sometimes referred to as inter-market spreads.
Imagine once again that you want to buy the July Chicago wheat contract because you believe prices are going to go up in the short term, but that you also want to hedge some of your exposure to the down-side. However, instead of hedging by using an inter-delivery spread or an inter-commodity spread, you decide to use an inter-exchange spread by hedging your long July Chicago wheat contract with a short July Kansas City wheat contract (traded on the Kansas City Board of Trade, or KCBT).
Chicago wheat and Kansas City wheat are quite similar. If one contract is trading at a higher price than another contract, you can buy the contract that is trading at the lower price and sell the contract that is trading at the higher price. By doing so you are buying low and selling high. If the two prices eventually converge once more then you will make a profit.
Inter-Delivery Spreads
