The futures market (part 6)

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The Futures market (part 6)

Futures Spreads Defined

Futures Spread Trading is a strategy of buying a particular futures contract and selling another but related contract against it all at the same time.  This strategy is also called pairs trading.  In pairs trading, one market within a sector is bought and a separate market in the same sector is simultaneously sold short.  This provides an investor with exposure to the relative performance of the two commodities with limited exposure to broader market and sector performance.

For example, let’s say you think the US is in the midst of a very strong and robust recovery and growth period (I know – it is very wishful thinking).  If that is true, then small cap equities will outperform large cap equities.  Smaller companies can grow much faster than larger ones in percentage terms.  A futures spread trader would see this as an opportunity to buy the Mini Russell 2000 and sell the Emini S&P 500.  The Russell 2000 is a small cap index and the S&P 500 is a large cap index.  In times of economic recovery and growth, small caps should outperform large caps.  In times of economic recession large caps should outperform small caps.

Futures Spread Trading:  is one way to trade futures contract. I will explain the basics of spreading so you will have a good knowledge in this important trading strategy..

Let us start with the various types of Futures Spreads.  I will start with what you can do with trading commodities.  Futures contracts that are spread between different markets are Inter-Commodity Futures Spreads. One example of this is Corn vs. Wheat. Let’s say the trader thinks that the Corn market is going to have higher demand than the Wheat market. The trade would buy Corn and sell Wheat. The trader does not care if the prices of Corn and Wheat go up or down; the trader only wants to see the price of Corn appreciate over the price of Wheat. If the grain markets sell off, the trader wants to see Corn hold its value better than Wheat. If the grain markets are bullish, the trader wants to see Corn advance farther than Wheat.

Intra-Commodity Calendar Spread

An Intra-Commodity Calendar Spread is a futures spread in the same market (i.e. Corn) and spread between different months (i.e. July Corn vs. December Corn). The trader will be long one futures contract and short another. In this example, the trade can either be long July Corn and short December Corn OR short July Corn and long December Corn. In order to be in an Intra-Commodity Calendar Spread, the trade must be long and short the same market (i.e. corn) but in different months (i.e. July vs. Dec).

Bull Futures Spread

A Bull Futures Spread is when the trader is long the near month and short the deferred month in the same market. Let’s say it is February of 2011. You buy May 2011 Corn and sell July 2011 corn. You are long the near month and short the deferred month (May is closer to us than July). It is important to note that the near months for futures contracts tend to move farther than faster than the back months. If corn is in a bull market, May (near month) should go up faster than July (deferred month). That is why this strategy is called a

Bull Futures Spreads. Since the front months tend to outperform the deferred months, a trader who is bullish on corn would buy the near month, sell the deferred month, and would like for the near month to move faster and farther than the deferred months.

This relationship between the near and deferred months is not always true 100% of the time, but it is the majority of the time. That is why when you are long the near month and short the deferred, it is called a bull futures spread. The spread should go in your favor when prices are rising.

Bear Futures Spread

A Bear Futures Spread is when the trader is short the near month and long the deferred month. This is the opposite of our Bull Futures Spread. Again, let’s say it is February of 2011. You sell May 2011 Corn and buy July 2011 Corn. You are short the near month and long the deferred month. This is a bear spread because the near months ten to move faster and farther than the deferred months. If Corn is in a bear market, May (near month) should go down faster than July (deferred month). This is not always true 100% of the time, but it is the majority of the time. That is why when you are short the near month and long the deferred month, it is called a Bear Futures Spread. This spread should go in your favor when prices are declining.

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