Or lose? Even though spread trading is sometimes referred to as a low risk way of trading the Futures markets, a trader can still lose money. The question becomes: how much did the trader make or lose when the spread changed value after entering a spread trade?
First let’s define a spread. A spread is simply subtracting the price of one market from the other. The net difference is referred to as the Spread. For example, July 13 Sugar is trading at 16.95 while October 13 Sugar is trading at 17.30. If you subtract the two prices from each other you will see that July13 Sugar is trading at a discount of .35 to October 13 Sugar. This .35 is what is referred to as the Spread of the July13/October13 Sugar Spread.
If a trader bought this Spread at .35 and over the next several days, weeks or even months the Spread widened to say .70 he would have a profit in the Spread trade. If the value of the Spread were to narrow down to .15 the trader would have a losing Spread position. The Spread value changes daily based on supply or demand of both contract months. If somebody thought prices were going higher in the Sugar market typically, but not always the trader would buy July13 Sugar and sell October13 Sugar. If they thought prices were going lower they would sell the July13 Sugar and buy the October13 Sugar. The reasons to place the trade either way would be based on if the market needed Sugar immediately or is it being put in storage for later delivery.
The two most popular types of Spreads are:
- Intra-Market Spreads
- Inter-Market Spreads
Intra-Market Spreads will be simultaneously long and short the “same” Commodity. These types of Spreads are the least risky of the two. The margin (capital deposited with clearing firm used to cover any losses a trader may have while in the trade) is less expensive due to the lower volatility and risk.
Inter-Market Spreads will be simultaneously long and short “different”, but related markets. These Spreads tend to be much more volatile and require higher overnight margin for each Spread.
Examples of Inter-Market Spreads:
- 10 Year Treasury Notes / 30 Year Treasury Bonds
- Live Cattle/ Lean Hogs
- Australian Dollar / Japanese Yen
- Heating Oil / Gasoline
Now that we are a little more familiar with what a Spread is and the different types of Spreads, just how do we determine our profit or loss when the Spread value changes?
Keep in mind that when you are trading Spreads you are still trading a Futures contract, actually you are trading 2 Futures contracts (one long and one short). The only thing you need to know to figure your profit or loss is what is the tick or point value in dollars for the Futures contacts in the Spread you are trading. That’s right, just like you learned in your Pro-Futures class.
In our example of the Sugar Spread above we can calculate our profit or loss by looking up the tick value (minimum amount the price can fluctuate) and then the dollar value of that minimum tick. The Sugar contract has a minimum tick value of $11.20. For every tick the price moves up or down the net result will be $11.20.
The first Sugar Spread we saw was purchased at .35 and moved up to .70 which is a net profit of .35. To find out what the value is we multiply 35 ticks by $11.20 and get a net dollar profit of $392.00.
The second Sugar Spread we saw was again purchased at .35, but this time moved down to .15 resulting in a net loss. The difference between what we paid for the Spread and the last trade is .20. If each tick in the Sugar contract is worth $11.20 then we multiply .20 by $11.20 and the actual loss would have been $224.
Once you enter a Spread then each day you will subtract the two contract prices from one another and compare the net difference (the Spread) to where you purchased the Spread. The math is exactly the same for all Intra-Commodity Spreads. Since you are both long and short the same contract just different months.
However, the Inter-Market Spreads can be different if the two markets you are trading have two different individual tick values. For example, if you were long the Australian Dollar and short the Japanese Yen they both have different tick values. The Aussie Dollar has a $10 tick value and the Japanese Yen has a $12.50 tick value. You cannot subtract these two Futures contract prices and get an accurate reflection of the value of the Spread.
To calculate Spreads where each Leg (the long position is a leg and the short position is a leg) is of different tick values a trader creates something called an Equity Spread. An Equity Spread will plot the actual contract values in dollar terms instead of ticks and points.
A point value (handle) in the Aussie Dollar contract is $1,000. The trader will take the last price on the screen for the Aussie Dollar and multiply it by $1,000. Today the Aussie Dollar is at 98.80. 98.80 X $1,000 = $98,800.
A point value in the Japanese Yen contract is $1,250. The trader will take the last price on the screen for the Japanese Yen and multiply it by $1,250. Today the Japanese Yen is at 97.95. 97.95 X $1,250= $122,437.50.
At the time of this article the Equity Spread value would be $23,637.50. We get this Equity Spread value by subtracting the Aussie Dollar contract value from the Japanese Yen contract value. The nice thing about plotting an Equity Spread is we can see the exact profit or loss in dollars and cents. If a trader was long this Inter-Commodity Spread and tomorrow the Equity Spread was worth $23,937.50 then the trader would know immediately he had made $300.
Fortunately most professional Futures charting packages computes this for you with each tick in real time. There are many different Inter-Commodity Spreads and this creates opportunity as one contract outperforms the other. A trader must be careful when trading these Inter-Commodity Spreads in markets that have Limit moves. There have been times when each leg has gone limit against the traders position. This is rare, but anything is possible in the markets and we must be prepared for this type of adverse move.
“Never regret. If it’s good, it’s wonderful. If it’s bad, it’s experience” Victoria Holt
- Don Dawson