Spreads to Limit Futures Trading Risk

Written by Aaron Adam

Futures trading is a high-risk, high-reward investment strategy, but there are a number of ways investors can decrease their risk of loss, the use of spreads being one of these methods.

Spread trading allows futures traders the opportunity to maximize their potential profits while limiting their exposure to risk. In futures trading, a spread involves the sale of futures contracts and the corresponding purchase of other futures contracts to offset the sales. The contracts being bought and sold are usually somehow related to one another. The futures trader's goal is to realize profit from expanding or contracting price difference between the contracts being bought and sold.

How it works

For speculative futures traders, spread trading offers a lower risk than trading futures outright. The reduced risk is because of the fact that the correlated long and short futures being traded more or less hedge one another, making the chance of loss much smaller. Because there's a reduced risk of loss, the margin requirements for futures trades involving spreads are usually less strict than for outright futures trading.

There's quite a bit of upside to trading spreads. Many investors use this strategy, because it is considered one of the more conservative options for futures trading and is considered by far to be one of the safest methods of futures trading. The margin discount aspect is also a major selling point for futures spreads because the discount can be between 25 and 75 percent. The lower margin requirements also increase the investor's chance of higher investment return ratio, offsetting some of the costs involved in futures spread trading. Also, spreads also tend to trend more than the outright trading of futures, and when outright futures are going nowhere, spreads are often trending.

Here's an example of a spread trade:

Let's say you've bought two contracts for corn futures. An October contract at $4 per bushel and a November contract for $3 per bushel. In your opening position, you've adopted a long position on the October contract (1,000 bushels) and a short position for the November contract (1,000 bushels). Your spread is $1, which is the current difference between the October and November contracts.

The October contract increases to $6 while the November contract goes up to $4. You could then sell your spread position by shorting the October contract and going long on the November contract to make a profit of about $1 per bushel. Your total profit would be $1,000. However, if the October contract drops to $3.75 and the November contract goes up to $3.50, the spread between the contracts is only $.25, and while the increase in value of your November contract makes up for some of your loss, you still will have a net loss. The loss is much less, however, than it would have been if you were just trading futures outright.

There's a variety of different spreads, but here's three basic types:

A horizontal spread consists of buying and selling two options on a futures contract of the same underlying commodity. The two contracts will have the same strike price, but their expiration date will differ.
Vertical spreads involve buying and selling two futures contracts of the same underlying commodity. The contracts will have a different strike price, but their expiration date will fall on the same date.
Diagonal spreads involve the buying and selling of two options contracts, with each contract having a differing strike price and expiration date. Diagonal spreads are also called money spreads.

Spread trading cons

While there are many pros to spread trading, there are also some downside to the strategy. Some futures exchanges do not consider all spreads low-risk, so the margin discount you may get for spread trading one type of commodity may not be available for another.

The learning curve for mastering spread trading is harsh. If you decide on spread trading, keep this in mind: If a futures trader makes use of a positively priced spread, the trader will want the price between the futures contracts to widen. In a negatively priced spread, the investor will want the prices of the underlying commodities being traded in the futures contracts to come closer together.

Also, don't forget that although the risk in spread trading is reduced, so is the potential for reward. Investors may have to put up large amounts of capital to see a worthwhile gain from spread trading because of its impact on rate of return.