Spread Trading: One of the Most Flexible Tactics of the Risk Management

Spread trading has long been the domain of seasonal commodity traders, whether it was to take advantage of old crop-new crop opportunities in agricultural commodities or to take advantage of interest rate discrepancies. Spread trading is simply the buying and selling of the same futures contract but in different months.

When an average investor decides to spread trade futures contracts he receives favorable treatment. This is similar to the favorable treatment that hedgers (those who actually buy and sell the actual commodity) receive. Since a spread trade is considered to have diminished risk (one side is long, the other side is short), the margin requirements are one half to one fourth the price of a stand-alone contract.

Let’s take the gold futures, for example. The futures margin is $2,025. If you decide to spread trade, the margin is only $608. This is a $1,417 difference.

There are many different criteria for why you would choose spread trading over an outright contract. You may believe that there is a discrepancy in price (contango versus backwardation activity), believe in the market’s long-term bullishness or bearishness, or weak or heavy supply and demand.

Regardless of what you use to determine your spread trade, it is definitely one of the most flexible of the risk management tactics. At the same time, it can be one of the more dangerous risk management techniques as well.

As a precautionary act to lock in profits and potentially catch any future giant leaps we go ahead and short the January 2007 contract while simultaneously maintaining the November 2006 position.

What’s the Worst that Can Happen?

Pick your spreading opportunities carefully. The worst thing that can happen is that you can lose on both legs of the spread. So even though you are gaining a reduced margin, if the November position starts to go down in value and the January position starts to go up, opposite of your current situation, you will mount twice as many losses.

The trick to working with spreads is twofold. First, you have to have a strategy. I prefer working with spreads when there are backwardation opportunities. We know that backwardation is unnatural, with the front months being more valuable than further-out months. When this occurs, there are opportunities to buy or sell the market. Depending on the expiration date and notice days you will pick and choose which contracts to buy and sell.

Particularly around contract expiration dates there are opportunities to benefit from price convergence. At this time the spot market and futures contracts prices have to match in order to eliminate excessive arbitrage opportunities. The only reason why backwardation exists is that there has been a fundamental shift in either supply or demand that has driven up the value. This change in value self corrects when the futures contract reaches expiration.

When using spreads, use a two-pronged trading strategy. The spread is the first line of defense; the second is money management parameters backed up with stop limits.

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