A futures spread is a combination of related futures positions that aim to make money based on the price relationship between a combination of positions while reducing risk. They generally consist of positively correlated legs, but can include legs that move in opposition to each other. Futures exchanges offer a lower hedge margin to hold them, but correlations do not always hold.
A futures spread is a combination of related futures positions, commonly known as legs. A single futures position not distributed, or directly, gains or loses money as the price of a commodity rises and falls, but a spread is designed to make money based on the price relationship between a combination of positions. A futures spread generally consists of legs that are positively correlated, meaning that their prices tend to move together. They can also include legs that tend to move in opposition to each other. Futures spreads attempt to capitalize on price relationships while reducing risk.
An example of a futures spread based on a positive correlation would be buying contracts on both heating oil and unleaded gasoline. Both are derived from crude oil and, as a general rule, their prices go up and down together. However, a trader might determine that heating oil inventories are lower than normal and gasoline inventories are higher than normal. If he or she expects refineries to correct the imbalance by diverting more of their capacity toward heating oil production and away from gasoline, the trader could buy a gasoline contract and sell heating oil. As inventories realign to their normal levels, the price of each tranche should move in the trader’s favor.
In general, this futures spread between commodities is a less risky proposition than simply buying the gasoline alone or selling only the heating oil. In the example above, if a hurricane cripples crude oil production, resulting in a shortage of heating oil and gasoline, both will tend to rise rapidly in price. A short, lone stretch on heating oil might be expected to lose a lot, but an extension that includes a long stretch on gasoline could make up for much, if not all, of the loss. The inventory spread would become a secondary factor, and the trader would be looking for a breakeven trade rather than a massive loss.
A correlated futures spread generally carries less risk than an absolute position, so futures exchanges typically offer a lower hedge margin to hold them. However, correlations do not always hold, and a spread can and occasionally goes just as bad as an absolute position. Other potential futures spreads can be built by buying and selling different contact months of the same commodity based on changing seasonal trends. By adding various combinations of options to the related futures contracts, the potential risk and reward can be adjusted to almost any taste.
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