Lessons from the Pros

Spread Trading Q & A

Spread trading is one of the topics we discuss in the Commodity Futures class. This style of trading is very good for smaller account size traders after they figure out how to trade these. The capital required to trade these Spreads is a fraction of an outright Futures contract. Figure 1 shows a comparison of an outright Corn contract to a Corn Spread.

Spreads generally move much slower than outright Futures positions, thus reducing some of the risk involved. By combining the use of Spreads and Seasonal Patterns of Commodities, we can get that added edge that most traders don’t have. Spread trading is one of the best kept secrets on the exchange trading floors. Not many small traders follow these, but you can be assured that the large traders and commercial traders are looking at and using these Spreads.

Question #1 – Execution – Is there a different symbol list for Spreads that the exchange recognizes, or is it simply an order on two separate symbols?

Answer #1 – Spread symbols are the same as outright Futures symbols. The difference is you are now trading two contracts simultaneously so the format for the symbols is different. We always post the buy side of the Spread first, then the Sell side. In this example, we are buying the December 2010 (Z10) contract and selling the March 2011 (H11) – Figure 2 shows the difference. (I will use the electronic symbols.)

Question #2 – If you were to buy the December 2010 Corn and not sell the March 2011 Corn simultaneously, is that considered an outright Futures position?

Answer #2 – Yes, until you have entered into the Spread with two different contracts, the exchanges would only recognize this as an outright Futures position. Trying to enter each contract individually is known as Legging into a Spread. This can be beneficial, at times, to get a better price on your Spread. One drawback is exactly what we just discussed; if it takes you more than a day to enter the second leg of the Spread, you can expect to pay the full initial margin on the contract you now hold instead of the reduced margin for a Spread.

Question #3 – Do you use Limit or Market orders to leg into your Spreads?

Answer #3 – I prefer not to leg into a Spread. If I have to do that, I usually use a Market order to make sure both legs are filled. If you are trading Intra-Commodity Spreads (same Commodity, different contract months) you will not have to ever leg into a Spread. If you are trading Inter-Commodity Spreads (different Commodities, but related to each other), you may have to leg into these. Ask your broker if a particular Spread takes a Spread Order and this will eliminate the legging in problem.

Question #4 – Do you use a stop loss on each contract, or does the Spread eliminate the need for physical stops?

Answer #4 – Once in a Spread, you always place your stop based on the Spread value and not the individual contracts. Remember, you have to use mental stops in the Spread market – the exchanges do not take stops for Spreads. If you place a stop on two different contracts, you could very easily be stopped out of one contract and still be net short or long the other Futures contract. If this happens, you would have to pay the full margin for the contract that is still open; you would have to manage your stop as your trade moved, be at risk of a limit up or down move against you, and your return on investment would go down because you have to use more working capital with an outright Futures position.

Question #5 – When charting the Spreads, do you watch the individual contracts or the Spread difference?

Answer #5 – Before entering the Spreads, I like to look at the individual contract charts for relative strength to one another. This helps confirm strength on the contract I am buying and weakness on the contract I am selling. After entering the Spread, I only watch the Spread difference chart. You can look at Spread charts using either a line on close chart or candles. Both will give you good support and resistance levels; trend lines and other technical tools will work well, too.

Question #6 – Do you use daily charts and then go down to intra-day charts to plot the Spreads?

Answer #6 – I prefer using daily, weekly and monthly charts for good support and resistance levels. The problem I find using intra-day data is that the bars can be erroneous, while the daily and higher time frames are based on settlement and actual ranges from the exchanges.

Here is what happens on intra-day data. Let’s say you are long December 10 Corn and Short March 11 Corn. Currently, there is much more volume in the December contract so that means there will be many more transactions than the March contract will have. December Corn can be trading several times moving away from the March contract. This gives the illusion your Spread is widening or narrowing for you. Until the March contract trades almost simultaneously with the December contract, the Spread is not really accurate.

The best way to track a Spread intra-day is to have a broker who has Spread trading access. Their quotes are based on the actual Spread being traded either on the electronic platform or in the pits and not by just subtracting the last price from one contract over the other.

Question #7 – If we see the broad market (stocks) continue to decline like we did in 2008, would you expect to see Commodities follow suit and abandon the Seasonal and Spread trades?

Answer #7 – One of the best things about the Futures markets is we can make money if the markets go up or down. When a Seasonal trade is overwhelmed with a fundamental situation like we had in 2008, you can actually go the other way with it. Think about this, if the Commodity has gone up 15 of the last 15 years during a particular window of time, and now a fundamental event is overwhelming that Seasonal, then you can bet that reversing the Seasonal trade will work very well. When something as reliable as a Seasonal pattern fails to work, you can bet there will be a lot of fear in the market. This creates opportunity for the trader who is trained to think out of the box and allows them to capitalize on the situation at hand.

I hope this article helped to clear up some questions about the Futures markets regarding Spread trading. For some of you this may be over your head at this time. If you find this type of trading to be of interest to you, please check out Online Trading Academy’s Commodity Futures class.

Trading Spreads opens up an all new opportunity in the trading arena. I hope to see you in one of our Commodity classes so we can show you how to spot some of these opportunities.

The next time you hesitate to try something new because of fear, please keep the following quote in mind. This is one of my all time favorites:

"Try a thing you haven’t done three times. Once, to get over the fear of doing it. Twice, to learn how to do it. And a Third time to figure out whether you like it or not." Virgil Garnett Thomson

Until the next time, keep the trades simple and green.

- Don Dawson