Futures Trading 
An Introduction To The World Of Future Trading
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Futures Trading  - Spread Strategy

Now, having explained that futures trading is very risky and highly leveraged, the reason I am explaining this strategy in detail is simply that it offers a relatively low risk way to enter the futures market using a hedging strategy. Trading index futures 'uncovered' or naked if you like is fine, provided you understand the risks involved, and as I have said before, please start with the smallest contract sizes such as e-minis. 

Futures Trading - The Spread

For those of you familiar with options trading, this strategy is very similar. In this case we look for two related futures contracts and buy and sell simultaneously. As a trader you are looking for the contracts to create a price difference or spread, before they have to be offset. Let's take a simple example and see how it works in practice, using two commodity futures which are related such as hogs and cattle. Now this is a directionless trade as we neither know, nor care, whether prices increase or decrease, as we will be buying one contract and selling the other. The important point is that we expect the prices to change at a different rate on each contract, so if prices increase you expect hog futures to increase faster than cattle prices, or cattle prices to fall faster than hog prices, thereby creating the difference or spread. In addition your spread strategy is also forecasting that cattle prices remain steady but hog prices may fall , or hog prices will remain stable and cattle prices rise. You do not care about absolute prices but only relative prices of one contract with another.  

OK, so let's take a look at some numbers. Live cattle futures trade at 40,000 lbs with 1 point = $4.00. Similarly lean hog futures trade at the same quantities and $4 per point. You believe that cattle futures prices will rise faster than lean hog prices, so you open the trade buy buying the cattle futures which are trading at 94.12 cents per lb, and sell the lean hog futures which are trading at 66.80 cents per lb. The spread between the two contracts is 27.32 cents.

Some weeks later your live cattle futures have indeed moved up faster and are now trading at 96.12 cents per lb whilst lean hog futures have only moved up to 67.50 cents per lb. The spread is now 28.62 cents.

So your losses and gains are as follows :

Live Cattle : 40,000 x (96.12 - 94.12) /100 =  +$800

Lean Hogs : 40,000 x ( 66.80 - 67.50 ) /100 = -$280

Profit on the spread trade = $800 - $280 = $520

This of course is the same as the change in the difference between the spreads, which have increased from 27.32 cents to 28.62 cents, an increase of 1.30 cents. If we multiply this by the trade size of 40,000 we get $520.

Now if we can use the spread trade in exactly the same way if we believe prices are going to fall faster in one future than another. The goal of spread trading is obviously to make more on the winning side of the trade than the losing side. Taking a spread position is less risky than a naked open position, but it is still possible to lose on both sides of the trade.

 

Now whilst the above is a very simple example you need to choose your contracts with care - they must be related, and you will also need to consider buying not only different expiry periods, but also on different exchanges. You will try to identify trends by studying all the market conditions before opening your positions. If nothing else, I hope that I have got one point across, that in order to be successful in futures trading you need to do your research, think outside the box, and study your market with the eye of economist or business investor. If you fail to read, study and plan you only have yourself to blame if you lose money fast ( and you will ). Just remember you are playing directly against professionals who will be experts in their fields and may only ever trade in one futures market - to win you need to do your research - leave your impulse trading style at the door.

OK - that I hope has given you some basic understanding of what futures trading is all about. I am working on several sites which will cover each market in more detail for you, so please check back regularly.

Thank you for getting this far, and I hope you found the site both interesting and helpful. As always, good luck in your futures trading and please keep in touch via the 'ask Anna' email link.

 


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