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Most speculators who have experience trading futures markets are pretty comfortable with outright directional positions: going long or short the market with the expectation of profiting from a favorable change in price either up or down. Trading futures spreads however may be less well understood and it is sometimes easy to confuse a spread position as two separate directional trades. How and why would a speculator trade a futures spread in addition to or instead of a directional long or short position in the market? How are spread positions different from outright directional trades? What are the expectations of the market when someone initiates a spread position?

As an introduction, a futures spread simply refers to the difference in value between two futures contracts. This can be what is called an intra-market spread, which is the difference in value between two contracts of different expiration months within the same commodity; or an inter-market spread, which is the difference in value between two contracts of different commodities. As an example, if July corn futures are trading at $3.75 per bushel and September corn futures are trading at $3.85 per bushel, the spread between July and September futures is equal to 10 cents (September over July). This would be an example of an intra-market spread. As another example, if Chicago July wheat futures are trading at $5.25 per bushel and Kansas City July wheat futures are trading at $5.75 per bushel, the spread between the Chicago and Kansas City July contracts is equal to 50 cents (Kansas City over Chicago). Here, even though we are comparing two wheat contracts, they are different markets and hence an inter-market spread. We could also compare the difference in value between two totally different markets such as wheat vs. corn, which would be an example of another type of inter-market spread.

Now that we have a working definition of what a futures spread is, let's move on to discussing a futures spread position. The process of placing a futures spread order involves buying one contract and simultaneously selling another contract in a one-to-one ratio. One purpose of this type of order many traders are probably already familiar with. If you have a long futures position in the market as a directional trade that is attempting to profit from an increase in price, you may come to the expiration of that contract before your price expectation is realized. Assuming you want to maintain your long directional position in the market, you might have to "roll" your long futures position into the next expiration month. As the contract reaches expiration, you would place an order to sell the contract you are long and simultaneously buy a contract in the next delivery month. You would do this so that you eliminate the risk of not having a position between the time you close out your existing contract and replace it with a new contract in the following expiration month. This can be done as either a "market" order in which the roll is executed at the best prevailing bid and offer for each of the respective contracts you are selling and buying, or it can be executed as a "limit" order in which the roll is executed at a defined difference in value between the two respective contracts.

In either case, because there is a pre-existing long position in the contract that is being sold, that leg of the spread is effectively closing the old long position while the long leg of the spread is creating a new position in a deferred contract. Because futures contracts expire and many directional trades will outlast the expiration of the contracts they were initiated in, futures spreads trades may comprise a significant portion of the trading volume on any given day -- particularly around contract expirations. Just as there is an active market for the underlying contracts themselves with competitive bids and offers determining where the contract is trading at any given point in time, there is likewise an active market in spreads for the difference in value between two futures contracts. Prior to the advent of electronic trading, market makers would keep track of the minute changes in value between futures contracts, and post bids and offers on the difference in value between contracts. With electronic trading, the computer can simultaneously monitor the difference between the bid on one contract and the offer on another contract to "imply" what a spread could be executed at between two different contracts. This implied spreading between contract values has allowed the electronic platform to execute spreads much more efficiently than what a human being is capable of doing, and many market professionals believe it was this development that accelerated the shift in futures trading volume away from the floor to the screen.

In the previous example, we examined rolling a long position into a deferred contract as one type of use for a spread order. What if there is no pre-existing long or short position in the market though? A spread order can still be placed to buy one futures contract and simultaneously sell another futures contract. In this case, one leg of the spread trade is not offsetting an existing position in the market. Both legs of the spread would therefore represent new open interest: you would have an open long position in one contract and an open short position in the other. Why would anyone want to do this? If for example I am long May Corn futures and short July Corn futures at the same time, wouldn't the gains in one contract be offset by the losses in the other? If the market goes up, I will be making money on my long May leg of the spread, but losing money on my short July leg of the spread. Similarly, if the market goes down, I will by making money on my short July leg of the spread, but losing money on my long May leg of the spread. While both of these statements are true, the catch is that both contracts do not necessarily move up and down by the same degree. If the May contract goes up by 10 cents, the July contract does not also have to go up by 10 cents. It may go up by 8 cents or it may go up by 12 cents. In other words, the contracts go up and down together, but not one-for-one. With an inter-market spread, the contracts may actually move in opposite directions. Just because corn futures went up yesterday does not mean that the wheat market went up also; it may have gone down. For that matter, even two corn contracts that represent different crop years might also move in opposite directions depending on the underlying situation in the market.

This brings up an interesting point about market movement. Just as the changes in contract prices are dynamic, the change in spread values between contracts is also dynamic. Sometimes, nearby contracts will gain value on deferred contracts. Other times, deferred contracts will gain value on nearby contracts. Just as traders have opinions on the underlying value of the contract itself in which they would wish to speculate on a directional move in price, they also have opinions on the difference in values between one expiration period and another, or even between the value of different commodities. Sometimes these types of positions are hedges in which the trader is trying to offset risk in the underlying cash market. A soybean processor for example may buy soybean futures and simultaneously sell soybean meal and soybean oil futures to lock in a crush margin. Similarly, an oil refiner may lock in a "crack" spread by securing the margin represented by the difference in value between crude oil futures and the distillate products as well as the gasoline contract. There is a relationship between the contracts, but they don't necessarily move together.

Let's go back to the example of an intra-market spread that represents the difference in value between two contracts of the same commodity. If one places an order to buy a nearby futures contract and sell a deferred futures contract, this is called a "bull spread." If instead one places an order to sell a nearby futures contract and buy a deferred futures contract, this is called a "bear spread." Depending on whether the contract with the earlier expiration is long or short therefore determines whether the position is a bull spread or a bear spread. With respect to these types of futures spreads, the direction of the underlying market is not necessarily indicative of how a spread will perform. In other words, just because a market is moving higher does not necessarily mean that nearby contracts are gaining value on deferred contracts. Similarly, just because the underlying market is moving lower does not automatically mean that nearby contracts are losing value on deferred contracts. It has been said that taking a spread position is a lower risk way of being long or short the market. This is a misconception. Sometimes in a bull market, nearby futures contracts are losing value on deferred futures contracts (bear spreads are working). Other times in a bear market, nearby futures contracts are gaining value on deferred futures contracts (bull spreads are working). Traders actually look for these clues as early warning signs that a pre-existing trend may be breaking down.

If I expect nearby futures to gain on deferred futures, I would want to be bull spread. Conversely, if I expect nearby futures to lose value on deferred futures, I would want to be bear spread. It does not matter if the underlying futures market is moving higher or lower, all that matters is how the contracts' values are changing relative to one another. Why would I execute this type of position? Just as there are historical tendencies for futures contracts to move higher and lower during different points of the calendar year, there are likewise historical tendencies for nearby contracts to gain value on deferred contracts, and vice/versa during different times of the year. Also, depending on what type of spread position I am looking at, the margin requirement can be considerably smaller than for an outright long or short position in the same market. This can allow you to trade several contracts of a spread for the same initial margin deposit as an underlying long or short futures position. Another advantage can be that depending on the spread, there may be much less perceived risk in the position compared to a directional position long or short the market. Again, this can be a misconception though depending on whether the position is a bull spread or a bear spread -- particularly a bear spread in an inverted market where nearby contracts are trading at a premium to deferred contracts. This is especially true in grain futures that cross crop years. To learn more, discuss with your broker whether or not spread positions can complement your existing trading and if spreads may be appropriate for your risk profile.

Chip Whalen is Senior Risk Manager and Director of Education for CIH Trading. Chip is a masters candidate with the Stuart School of Business and he oversees the research efforts at CIH and advises on its successful risk management tools. Chip conducts educational seminars for current clients and a variety of academic institutions and member organizations, including the CME Group, Northwestern University, and the American Soybean Association. CIH Trading is a full-service introducing broker that specializes in agricultural commodities. Chip welcomes your feedback at info@cihtrading.com.

Better Trading Decisions Start with CIH Trader

Learn how CIH Trader can improve your decision-making process. As Ag and Livestock experts, we help clients make objective decisions and better understand choices. Sign up for a demo of CIH Trader, our trade reports and unique decision-making tools.

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