Spread trading is a trading approach that is less common, yet offers huge potential to developing and advanced futures traders alike.
So, what exactly is spread trading? In this post, let’s explore all you need to know about the basics of spread trading!
Outright Trading vs Spread Trading
There are 2 ways to trade. The first approach is called outright trading, where traders speculate on the direction of an asset. This is the most common way traders use to trade the market.
The second approach is called spread trading. Through spread trading, traders speculate on the price difference between 2 futures contracts.
2 categories of spread
There are 2 categories of spread, namely Intra-market spread and Inter-market spread:
Intra-market spread: Spread positions in one futures market (eg. Natural gas)
Inter-market spread: Spread position between closely related markets (eg. Natural Gas vs Crude Oil)
Calendar Spread 101: What you need to know about Calendar Spead
For this post, we are going to focus on intra-market spread trading.
The most common style of intra-market spread trading is calendar spread, which is the action of buying and selling contracts of the same asset class that expire in different months.
For instance:
Price of Natural Gas in October 2023 (V23 contract) = $2.764
Price of Natural Gas in November 2023 (X23 contract) = $2.977
Calendar spread = NGV23 - NGX23 = $2.764 - 2.977 = -0.213
In this example, when you buy a calendar spread, you are essentially buying NGV23 (Oct 2023) (near-month futures contract) & selling NGX23 (Nov 2023) (far-month futures contract) at the same time.
In other words, when you buy a calendar spread, you are essentially taking 2 positions by buying 1 contract month and selling another contract month in the futures market.
Meanwhile, selling a calendar spread means you are selling NGV23 (Oct 2023) (near-month futures contract) & buying NGX23 (Nov 2023) (far-month futures contract) at the same time.
Why trade calendar spread?
(i) Less price volatility risk
Generally, spread trading tends to move in a more stable manner compared to outright trading.
For instance, in dollar terms, an outright natural gas (NG) contract may move up to $1080 (ATR of $0.108 x 10,000 contract size) on any given day (at the point of writing this post).
Meanwhile, a NG spread contract may only move about $190 on any given day. (ATR of $0.019 x 10,000 contract size)
(ii) Lower margin requirement
Considering the lower volatility nature of spread trading, brokers tend to require less upfront margin from traders to initiate a calendar spread trade compared to an outright trade.
Check out the margin required for various outright Natural Gas contracts:
Meanwhile, check out the margin required for various calendar spread contracts for Natural Gas, which differ according to the period of the calendar spread:
Simply put, calendar spread traders require less upfront margin to initiate a trade compared to outright trading.
Contango & Backwardation
To truly understand calendar spread trading, it is important to be familiar with 2 key phenomena in the futures market:
(i) Contango:
Contango happens when the price of the spot or near-month is lower than the far-month contract (or forward contract), producing an upward-sloping price curve.
This is common in most physical futures market due to the ‘cost of carry’ (ie. Cost to store or hold a physical position) like gold.
This is also common in market that shows strong seasonality, such as Natural Gas (which is used for heating), where the price in autumn tend to be lower than in winter months due to a difference between supply and demand, forming a Contango between months like October (autumn) and January (winter).
(ii) Backwardation:
Backwardation happens when the price of the spot or near-month is higher than the price of the far-month (or forward contract), forming a downward-sloping price curve.
Natural gas is an example where price during winter months tend to be higher than in spring due to the difference between supply and demand, forming a Backwardation between months like February (winter) and March (spring).
In short, factors like seasonality, inflation, inventories, and weather conditions can have an impact on the contango and backwardation phenomenon in the futures market.
How to interpret and trade a spread:
Bull Spread = Trader buys near-term contract month, and sells the forward month, anticipating that near-month price will appreciate faster or hold its value better RELATIVE to forward month’s price.
eg. Buy 1 contract of V23:X23 in the futures market = Buy 1 contract V23, sell 1 contract X23.
How to profit from a bull spread?
Buy 1 contract at 5 points spread today, spread widens to 9 points next week = You make 4 points in profit.
Bear spread = Trader sells near-term contract month, and buys the forward month, anticipating that near month price will fall faster or decrease in value further RELATIVE to forward month’s price.
eg. Sell 1 contract of V23:X23 in the futures market = Sell 1 contract V23, buy 1 contract X23.
How to profit from a bear spread?
Sell 1 contract at 5 points spread today, spread narrows to 3 points next week = You make 2 points in profit.
Outright Trading vs Spread Trading: The difference
It is important to note that the interpretation between bullish and bearish in spread trading is slightly different compared to outright trading.
For instance, being bullish or bearish in outright trading refers to the price of an asset or futures contract going up or down.
Meanwhile, bullish and bearish in spread trading refer to the idea where the value of the spread would widen or narrow.
Downsides of spread trading
Higher commissions: Since trading a calendar spread involves buying and selling 2 different futures contracts, it is considered 2 trades and hence incurs 2x the commission as compared to outright trading.
Lack of information: Unlike outright trading, the information around spread trading is relatively rare on the internet.
More complex to learn: Considering the multiple dimensions involved with spread trading, it is certainly more complex to learn and master compared to outright trading which most of us are familiar with.
Verdict: Explore the exciting world spread trading!
I hope this introduction of spread trading makes it easy for you to understand what exactly is spread trading!
In future articles, we shall dive deeper into various topics of spread trading, such as forming a trading idea and strategies!
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Disclaimers
Any of the information above is produced with my own best effort and research.
This post is produced purely for sharing purposes and should not be taken as a buy/sell recommendation. Past return is not indicative of future performance. Please seek advice from a licensed financial planner before making any financial decisions.
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
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