While most people think of trend following when they think managed futures, the asset class has expanded to include a wider variety of strategies. One such strategy is spread trading, which is an attempt to turn a profit off of the difference between the prices of two contracts (not to be confused with spread betting, which is how UK traders are able to sell short). A trader can buy the spread (which means selling the cheaper contract and buying the more expensive contract) hoping that the gap between the two contracts will widen. Or, a trader can sell the spread (buy the cheaper contract and sell the more expensive contract) hoping that the gap between the contracts will narrow.
For instance, let’s say the May contract for corn is trading at $6.00, while the July contract is trading at $5.50. If you buy May and sell July (buying the spread), you will profit if the price difference expands. If you sell May and buy July (selling the spread), you will profit if the price difference narrows. The advantage of a spread trade is that the general direction of the market doesn’t matter to the trader; whether the markets traded are increasing or decreasing in value, all that matters is that the spread is growing or shrinking. While such a trade can be placed in a variety of manners, there are several traditional spreads that are used frequently across the industry:
- The Calendar Spread - The above scenario is an example of a calendar spread, the most common type of spread trade in use. The idea here is to try to take advantage of the price differences for one month’s contract over another within the same market. This is also called an “intra-market” spread, to distinguish it from “inter-market” spreads that trade contracts in different markets.
- The Inter-Exchange Spread - This strategy tries to profit from imbalances between similar commodities traded on different exchanges, such as Kansas City Wheat versus Chicago Wheat, or West Texas Intermediate Crude versus Brent Crude.
- The Crack Spread - No, not related to the drug. The crack spread refers to a spread trade between crude oil and one of its byproducts, like heating oil or gasoline. Its name is derived from the idea of “cracking” the crude oil to get useable products out of it.
- The Crush Spread - Similar to the Crack spread, this trade revolves around soybeans and their byproducts. Traders will buy or sell soybean futures and either soybean meal or oil.
- The NOB Spread - Spread trading isn’t just for commodities, as the NOB spread tries to take advantage of the difference between 10-year Treasury notes and 30-year Treasury bonds (Notes Over Bonds).
- The FAB Spread - Like the NOB spread, FAB trades involve bonds with different maturities, in this case seeking to capitalize on the difference between 5-year treasury bonds and longer-term bonds (Five Against Bonds).
- The TED Spread - The TED spread looks for profit in the difference in interest rates between three-month US T-bills and three-month Eurodollar deposits, which are time deposits in banks outside the US, but still denominated in US dollars.
Now the idea with these and more complex spreads is technically risk management – the hope is that losses on one side of the trade are offset by larger gains on the other side. Several CTAs we follow at Attain engage in spread trading such as Emil van Essen and Rosetta. However, there is always the risk that the spreads go in the opposite direction that you’d like them to… and in a big way. For this reason, though spread trading programs can benefit your portfolio, they won’t be right for everyone.