Spreading - Spread Trading

Of the 120 questions on the Series 3 exam, you can expect around three on spreading.

Spread trading
In the preceding chapter, we described hedges, then showed examples of how you can take a primary position in the cash market and reduce the risk inherent in that position by taking a contrary position in the futures market.

But let's say that the cash market is, for any number of reasons, unattractive to you as a commodity producer, as a commodity consumer or as a financial speculator. In fact, if you're trading financial as opposed to agricultural contracts, the futures exchanges may be the most robust market available. In either case, you might want to take both your primary and your hedge position in the futures market.

Definition and Objective
A spread combines both a long and a short position put on at the same time in related futures contracts. The idea behind the strategy is to mitigate the risks of holding only a long or a short position. For example, a trade may have put on a spread in gold. If gold increases in price, the gain on the long position will offset the loss on the short one. If gold were to fall, the reverse would hold. As with any protective trading arrangement, a spread may be vulnerable to both legs moving in the opposite direction of what the trader may have anticipated, losing money. Margin requirements tend to be lower due to the more risk adverse nature of this arrangement.

Tips & Tricks

The candidate should note the basic taxonomy of spread types and be able to identify them, to wit:

  • Intracommodity: the spread is on the same commodity
  • Intercommodity: the spread is on different commodities.
  • Intramarket: the positions are traded on the same exchange.
  • Intermarket: the legs of the spread trade on different exchanges
  • Intradelivery: the contracts mature in the same delivery month.
  • Interdelivery: the contracts mature in different delivery months.

Ex. A customer is long December copper and short March silver. They both trade on the New York Mercantile Exchange. What spread is this?

  • Intercommodity - though copper and silver are both metals, they are different.
  • Intramarket - both trade on the NYME.
  • Interdelivery - one is delivered in December, the other in March.

* Mnemonic device - intra: within; inter: between *

LOOK OUT!

Please review "Chapter 4: Market Operations," particularly the "Alternative calculations" heading under the "Margin requirements" section.

In addition to reduced margin requirements, time and labor-saving devices exist for spreads. Most exchanges feature an order entry system that enables a trader to enter or exit a transaction using a "spread order," an order listing the series of contracts that the customer wants to buy and sell, and the desired spread between the premiums paid and received for the options.

Say, for example, it is August and you want to buy a September hard red winter wheat contract for $4.70/bushel and sell a December wheat contract for $4.85/bushel on the Kansas City Board of Trade. So you enter it all in on one spread order, rather than as one long position and one short position. (The first benefit you will realize is that your margin requirement – for both initial and maintenance positions is $100 per 5,000-bushel contract rather than $1,000 per contract.) The difference or, to use a term from hedging, the basis, is -$0.15/bushel.

Alternately, a trader could independently enter each side, or "leg," of the spread, but this is not commonly done because the spread can now be considered a single, synthesized position. As well, it is no longer a position on the price moves of the wheat itself. It is now a position on whether the basis will narrow or widen.

Expectations
In the example above, the spread could actually gain (or lose) in value, even if there is no movement in one of the legs. As stated, one of the legs is for September delivery and it is already August. There might not be much more play in that price of that futures contract; as it approaches its expiration date, it will stick closer and closer to the spot market price. Still, December is a long way off, and one of two things will happen: either the December price will go up, or the December price will go down. If the December price goes up (pursuant to our example), then the basis will widen. If the price goes down (assuming the bottom does not fall out altogether), then the basis will narrow.

The spread will continue to trade as a spread, rather than as two separate positions. There is even a market in spreads as opposed to the uncovered positions. Just as futures prices are typically higher than cash prices (as discussed in the preceding chapter), distant-futures prices are normally higher than nearby futures prices. Thus, December prices will usually be higher than September prices, and so the normal state of a spread basis is to be negative. But there are conditions that can lead to an inverted market, in which distant-futures prices may be below near-future prices, resulting in a positive basis.

Bull and Bear Spreads in Normal Vs. Inverted Markets
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