Futures trading offers a multitude of opportunities for traders which include leveraged trading, speculation, and enables them to construct strategies that offer uncorrelated returns to the general market.
In the previous blog post, we dived into the mechanics of basis trading which exploits the price differential between spot and futures prices. In this article, we shall expand into another market neutral strategy that is widely used in traditional futures markets. This strategy is also known as spread trading.
What is spread trading?
Spread trading is the simultaneous buying and selling of two related futures contracts. For example, if you bought the BTCUSD September contract and sold the BTCUSD December contract, you would have a spread trade.
In a spread trade, you are trading the price differential between two contracts. In a spread position, you would want the long side of the spread to increase in value relative to the short side or vice versa.
Let’s say you bought a BTCUSD September contract at $9,500 while simultaneously selling a December contract at $9,600. This creates a spread position with a price differential of -100.
The relative performance of September and December contracts
Let’s say at T+1, the value of September contract gains by $200 from $9,500 to $9,700 while December contracts remained unchanged, your net PNL would be $200 in the money. In this case, the spread would move from -100 to +100.
However, on T+2, the value of the December contract outperformed and rose from $9,600 to $9,900 while the September contract remained unchanged. This means that the spread moves from +100 to -200, resulting in a net P&L loss of $200 on your position. As you can see, the relative performance of the two contracts determines your profit or loss.
The example shown is the most common form of spread trading which is also known as Intramarket Spread or Calendar Spread. Calendar spreads became a coined term as it involves the buying and selling of two different delivery months in the same market.
4 Reasons to Spread Trade
Spread trades allow you to profit regardless of market direction, as long as the price differential between the two contracts moves in your favor.
Spread trades consist of two underlying futures contracts which are leveraged products, this means you are only required to deposit into your account a small percentage of the total value of your trade.
Spread trades make trading accessible to all; low minimum trade sizes and transactional costs make this strategy popular with thousands of retail and professional traders around the world.
Spread trades reduce volatility and systemic risk, when external events move the market, both legs of the spread trade are often affected equally, thus volatility and explosiveness are diminished compared to trading outright prices.
Key Risks to Manage when Spread Trading
Leverage: While leveraged trading can boost returns, it can also compound losses. As a trader, you need to assess your risk profile and consider using our risk management tools to help protect yourself from losses if the markets move against you.
Execution risk: In volatile periods, executing two-legged spreads can be a challenge. In these periods, price movements can be sharp and fast-changing which may lead to slippages.
Gapping risk: Gapping is a price movement where no trade occurs. This could be caused by unexpected news events or the lack of liquidity in the market. It is important to understand that a gap in the market can adversely affect your trades and your capital, this means that you have to carefully select a position size that helps minimizes this risk and matches your risk appetite.
Getting Started With Spread Trading On Binance
Step 1: Plot prices of September and December contracts.
Here is a set of hypothetical prices for BTCUSD September and December contracts. Typically, prices of quarterly contracts track each other very closely. This is what we want to replicate in this example.
Step 2: Plot out the price differential between the two contracts and determine trade entry and exit.
We have magnified the scale to show the amount of spread between the September and December contracts. In this scenario, a technical trader might note that as the spread has reached resistance as the price differential hit 70. Meanwhile, as it drops to the 50 range, it hits support. This creates opportunities to capitalize on small gains as the spread approaches these key areas, where these patterns may lead to trade entry and exit points.
Step 3: Putting on a spread position
We enter positions around the resistance and support levels that the spread forms. At these resistance areas, we want to sell the spread. While at support areas, we want to buy the spread.
To buy spread: Buy the September contract (front-month) and sell the December contract (back-month)
To exit spread: Reverse the trades on respective legs as the spread reaches the desired target price.
As shown, this strategy is geared towards small and repeatable profits. Spread trading offers several benefits to your portfolio, including diversification from directional strategies, the ability to reduce the volatility of a portfolio, and cushion against a market decline.
Is Spread Trading for you?
As you know, spread trades reduce volatility and systemic risk which is a huge advantage to many spread traders. Spread trades allow you to participate in the market in a consistent and stable manner, as opposed to pursuing occasional outsized gains.
Given that spread positions are hedged, it protects traders from extreme market movements as the overall position is less volatile than the movement of individual futures prices. For example, if a piece of news caused a sudden price drop on one side of the spread, the same movement will mean that we benefit from the other side of the spread.
Spread trading has many advantages, as well as some disadvantages. Spread trading is unique and less competitive, furthermore, it offers uncorrelated returns to the general market. Therefore it may be an excellent arena if you are willing to study and practically implement your knowledge about how prices relate to one another.