What Is a Spread?

What Is a Spread?

A spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts. You can turn that around to state that a spread is the purchase of one or more futures contracts and the sale of one or more offsetting futures contracts. A spread is also created when a trader owns (is long) the physical vehicle and offsets by selling (going short) futures. Furthermore, a spread is defined as the purchase and sale of one or more offsetting futures contracts normally recognized as a spread by the fact that the two sides of the spread are actually related in some way. This explicitly excludes those exotic spreads put forth by some vendors, which are nothing more than computer generated coincidences which are not in any way related. Such exotic spreads as Long Bond futures and Short Bean Oil futures may show up as reliable computer generated spreads, but bean oil and bonds are not really related. Such spreads fall into the same category as believing the annual performance of the U.S. stock market is somehow related to the outcome of the Super Bowl sporting event. In any case, for tactical reasons in carrying out a particular strategy, you want to end up with:

• simultaneously long futures of one kind in one month, and short futures of the same kind in another month. (Intramarket Calendar Spread)
• simultaneously long futures of one kind, and short futures of another kind. (Intermarket Spread)
• long futures at one exchange, and short a related futures at another exchange. (Inter-exchange Spread)
• long an underlying physical commodity, and short a futures contract. (Hedge)
• long an underlying equity position, and short a futures contract. (Hedge)
• long financial instruments, and short financial futures. (Hedge)
• long a single stock futures and short a sector index.

The primary ways in which this can be accomplished are:

• Via an Intramarket spread.
• Via an Intermarket spread.
• Via an Inter-exchange spread.
• By ownership of the underlying and offsetting with a futures contract.

Intramarket Spreads

Officially, Intramarket spreads are created only as calendar spreads. You are long and short futures in the same market, but in different months. An example of an Intramarket spread is that you are Long July Corn and simultaneously Short December Corn.

Intermarket Spreads

An Intermarket spread can be accomplished by going long futures in one market, and short futures of the same month in another market. For example: Short May Wheat and Long May Soybeans.
Intermarket spreads can become calendar spreads by using long and short futures in different markets and in different months.

Inter-Exchange Spreads

A less commonly known method of creating spreads is via the use of contracts in similar markets, but on different exchanges. These spreads can be calendar spreads using different months, or they can be spreads in which the same month is used. Although the markets are similar, because the contracts occur on different exchanges they are able to be spread. An example of an Inter-exchange calendar spread would be simultaneously Long July Chicago Board of Trade (CBOT) Wheat, and Short an equal amount of May Kansas City Board of Trade (KCBOT) Wheat. An example of using the same month might be Long December CBOT Wheat and Short December KCBOT Wheat.

Why Spreads?

The rationale behind spread trading is one of the best-kept secrets of the insiders of the futures markets. While spreading is commonly done by the market "insiders," much effort is made to conceal this technique and all of its benefits from "outsiders," you and me. After all, why would the insiders want to give away their edge? By keeping us from knowing about spreading, they retain a distinct advantage.
Spreading is one of the most conservative forms of trading. It is much safer than the trading of outright (naked) futures contracts. Let’s take a quick look at some of the benefits of using spreads:

• Intramarket, and some Intermarket, spreads require considerably less margin, typically around 25% - 75% of the margin needed for outright futures positions.
• Intramarket, and some Intermarket, spreads offer a far greater return on investment than is possible with outright futures positions. Why? Because you are posting less margin for the same amount of possible return.
• Spreads, in general, trend more often than do outright futures.
• Spreads often trend when outright futures are flat.
• Spreads can be filtered by virtue of seasonality, backwardation, and carrying charge differentials, in addition to any other filters you might be using in your trading.
• Spreads can be used to create partial futures positions. In fact, virtually anything that can be done with options on futures can be accomplished via spread trading.
• Spreads allow you to take less risk than is available with outright futures positions. The amount of risk between two Intramarket futures positions is usually less than the risk in an outright futures position. The risk between owning the underlying and holding a futures contract involves the least risk of all. Spreads make it possible to hedge any position you might have in the market. Whether you are hedging between physical ownership and futures, or between two futures positions, the risk is lower than that of outright futures. In that sense, every spread is a hedge.
• Spread order entry enables you to enter or exit a trade using an actual spread order, or by independently entering each side of the spread (legging in/out).
• Spreads are one of the few ways to obtain decent fills by legging in/out during the market Closing.
• Live data is not needed for spread trading, saving you $$ in exchange fees.
• You will not be the victim of stop running when using Intramarket spreads.