Spread trading: Capitalizing on market relationships
Among the many styles of trading used in managed futures, one of the most unique is spread trading. In most traditional investments, you buy what you think will go up and sell what you think will go down. But in spread trading, you simultaneously buy and sell two closely related futures contracts — such as buying corn for May 2011 delivery and selling corn for December 2011 delivery — with the objective of profiting from the price changes between the two delivery dates.
While related markets generally move in tandem, the difference between the prices of the two futures contracts — the “spread” in spread trading — can be very profitable. In the buy May-sell December corn spread, the trading manager puts on a “calendar spread” in which he believes the corn market will go up and the front-month contract (May) will increase more than the backmonth contract (December).
On Feb. 1 the trader bought May 2011 corn at $6.77 per bushel and sold December 2011 corn at $5.96 per bushel (Figure 1). The price of May and December corn moved generally in the same direction during the life of the trade. However, the spread between the two contracts widened and narrowed, creating profit and loss (Figure 2).
On the first day of the trade, the spread between the two futures contracts was 80 cents. By the end of February, the spread had widened by 44 cents to $1.24 — a $2,200 gain, since each futures contract represents 5,000 bushels of corn (5,000 bushels x 44 cents per bushel = $2,200). However, by mid-March the spread had narrowed to 67 cents per bushel (a $650 loss on the spread) before rallying again in early April. Like any liquid security, the trader can close the trade and take his profit or loss at any time during the life of the trade.
Calendar spreads (sometimes called “intra-commodity spreads”) are only one example of spread trades. Any two closely related futures contracts can be paired to establish a spread. Some of the more popular ones include yield spreads that take advantage of anticipated changes in the yield curve of debt instruments (three-year Treasury notes and 30-year Treasury bonds, for example), “crack” spreads that pair unrefined petroleum products like crude oil with refined products such as gasoline, and spreads that trade the relationship between distinct but related commodities (gold vs. silver, corn vs. wheat).
Increasing popularity
While spread trading has been around for as long as the futures markets, commodity trading advisors (CTAs) have increased their use of spreads in recent years. Some CTAs specialize in spread trading while others blend the technique with other trading models.
“We incorporated spread trading within our trading programs because of its lack of correlation to other trading styles,” says Kevin Jamali, managing partner of Auctos Capital Management. “When we run correlation analysis with our other programs, we see that we have a 0.3 or 0.4 correlation between our spread programs and our trend-following and pattern-recognition programs. If you look at our returns in 2009-2010, we outperformed many of our peers and a lot of that is attributed to our spread program.”
“Spread trading is another level of diversification,” says Walter Gallwas, president of Attain Capital Management, a firm specializing in managed futures through individually managed accounts. “We like to put spread traders together with the trend followers, short-term traders, and option traders. Everyone is going to be doing something different at any particular time, so you can take advantage of different phases of the market.”
Advantages in choppy markets
Different trading styles are designed to take advantage of different types of markets. Trend followers profit from large, long-term price moves. Option programs often profit from quiet, sideways markets. One of the advantages of spread trading is that it can profit in choppy markets that other trading styles find very difficult.
“In spread trading you’re betting on a relationship of one commodity to another, which is a lot different from making a bet on a big move,” says Phillip Herbert, CEO of NDX Capital Management. “Spread trading is for people who don’t want to be gunslingers with their money.”
“Spread trading can generate profitable returns while many of the traditional trend-following programs are waiting for trends to develop,” Jamali adds. “If it’s not making a lot of money, at least it’s playing good defense and not losing much.”
Risk is always present
Many novice investors wrongly perceive spread trading as risk-free.
“If you spread trade correctly, there are ways to control your risk a little bit more than with outright positions, because one leg of the spread will offset the other to a degree,” Gallwas says. “But you can’t make the assumption that volatility or risk will be reduced all the time because there will always be outlier effects. You can have back months that are effected by droughts or exports that increase volatility.”
Consult your advisor
Spread trading can add an important component to your managed futures investment. But like all investments, it helps to have the advice of a financial professional to determine the size, timing, and combination of investments.
