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Track 'n Trade Futures End of Day Spreads

What are Spreads?

Video Transcript

Lan: Welcome to Track 'n Trade Pro and our introduction to the Spreads module. My name is Lan Turner and I'm sitting here with Scott Barry. The first thing I want to do here is introduce you to what the definition of a Spread is. The Futures markets provide a variety of trading opportunities. In addition to profiting from rising prices by purchasing Futures options or from falling prices, by selling Futures contracts, there is an opportunity to profit from the relationship between different contracts, or spreads.

A spread refers to the simultaneous purchase and sells of two or more different Futures contracts. Let me read that again: A spread refers to the simultaneous purchase and sales of two or more different Futures contracts. Here are some definitions for you.

Spread: The Spread is the price difference between two different but related contracts.

Spreading: Simultaneous buying and selling of two related markets in the expectation that a profit will be made when the position is offset. Here's an example the example include: Buying one Futures contract, and selling another Futures contract on the same commodity, but different delivery months. Buying and selling the same delivery month on different exchanges, or buying a given delivery month on one futures contract and selling the same delivery month or close to it of a different but related futures market.

Now, Scott, go ahead and give us layman's description. What are Spreads?

Scott: Spreads is like going to the race track; when we trade Futures and or standard futures contract or futures position, it's like betting a horse to win. Spreads are much closer to betting a horse to show or come in third place. What you're doing is you're trading a differential between the two. It's what is considered a partially hedged position because it involves a long position and a short position.

Maybe we can take a quick look here at a theoretical- let's look at buying July Chicago Board of Trade Wheat and selling December Board of Trade Wheat. Let's take a look and assume when we go to put this position on that in week 1 the July contract is trading at 285 and December contract is trading at 295. There is a 10 cent differential. Because the July is trading under the December contract, we say it's trading 10 cents under a minus 10.

Now, let's say a week goes by and our July Wheat goes up to 300, $3.00 a bushel. We're happy, we're long July Wheat at 285. It went up to $3.00 a bushel, that's 15 cents, $750.00 before commissions and fees. Now, on the other side it sold December Wheat, let's say it went from 295 that we put it on to say 305. It only increased 10 cents, now we're short that. We don't like that, we actually lost on that one $500.00 a bushel. But because the one that we were long or our July contract out performed the one that we were short. What we were long went up 15 cents, what we were short went up 10 cents, we netted a 5 cent differential on this, or we made $250.00.

So basically when a Spread, when you put on a spread you're saying that the long contract increases in value or you're betting that the long contract increases in value more than the short contract.

Lan: The thing that I had initially had a hard time understanding between spreads, Scott, is that you're not really concerned about the price of the underlying spread or contract. You're really more concerned just about the difference in price between the two that you're looking at the two contracts. You don't care whether corn is expensive, on this contract and looking for it to drop, or you don't care if one or the other, either way, the price of the underlying contract is. You're more concerned about the differential the difference between the two contracts you're spreading.

Scott: Exactly, you're looking at the outright markets are the outright markets. Also, the spread is a market in it of itself. So, it would be almost equivalent to, we're going to try to trade the cattle market by only looking at the hog charts. They are related, but they're not the same. It is very important to look at when you're trading Spreads and the whole purpose of this software is to look at the spreads. Look at the differential, you're concerned with is the differential sheep or deer. Not is the underlying market sheep or deer; because you make money if the one year long gains in value relative to the one you're short.

Lan: That doesn't mean one has to go up and one has to go down. It just means that one has to go up less than the other one, or down less than the other one.

Scott: Right, if we looked at in our last example, why don't we switch over, we can see that the number here are good examples.

Lan: Is that what you want to go is the individual contracts.

Scott: Yeah, we can take real quick look, if we're looking at a July December spread in wheat or the Chicago Board of Trade Wheat. You can see in that, that's kind of a sideways slightly down trend.

Lan: Quite the whipsaw, it goes up and down.

Scott: Very trade rangy, very, very typical of Wheat.

Lan: Then, of course, we look at the July contract. Those are very, very similar. They're almost exactly when we lay them there, they're almost exact.

Scott: Now, we go back to our, if we go back to our spreadsheet chart.

Lan: The differential between those two..

Scott: Yeah, had a very nice and neat downtrend to it.

Lan: Yeah, it's not the whipsaw that we saw in the individual underlying contracts.

Scott: Exactly, you know so, looking at the individual contracts, which we're generally going kind of sideways more than anything else, looking at the spread chart; it went straight down.

Lan: But that's because we're not charting down the price of the underlying commodity of corn, we're just charting the difference between the price of the two contracts.

Scott: Right, we're concerned with the differential, not the absolute price. If we- why don't we look at, when you put on a spread position, you have a long position, and you have a short position. You can make money three ways. They all end up being the same thing, is you want your long to out-perform your short. If they both go up, like we talked about in our first example. You know, where we bought July Wheat at 285, and we sold December Wheat at 295, if they both go up, we want to see July Wheat increase in value, relative to December Wheat. Which in our first example here, we've made $750.00 or 15 cents on our long position, we lost 10 cents or 500 bucks on our short. The differential in the Spread, we picked up 5 cents.

Lan: Or $250.00.

Scott: Yeah, or $250.00, exactly. Now, if we look at the next- as you had said earlier they don't both have to go up. Markets don't always go up, sometimes markets go down. Let's look at the at the next one. We can make money if our long position decreases in value, less than our short position.

Let's say again, we bought July at 285, we sold December Wheat at 295. Instead of the market rallying this time, Wheat prices break. Our July contract drops 10 cents. It goes from 285 to 275. We're not happy about that, we just took a 10 cent or a $500.00 hickey on that. Now, we had sold our December Wheat at 295 and it dropped to 280. We just picked up 15 cents there, $750.00. That's not a bad weeks of work. I'm kind of dancing a jig on a per contract basis.

The key thing is why we're truly happy, is that the December contract that we're short decreased in value more than the one that we were long, or long. Again, the one that we were long, gained relative to the one we are short, or the spread increased in value.

Lan: Therefore, we made a profit of $250.00. Even though we lost $500.00 on our long contract, we made $750.00 on our short contract, therefore our profit is $250.00, or the spread difference between those two contracts.

Scott: Yeah, and it is not uncommon to see in a market, you know, we could take that same spread we were looking at earlier, when we saw the two different wheat contracts, basically going sideways in a very big whipsaw market. We saw this spread, the actual spread itself having a very nice distinct unique downtrend to it. The third situation, you know, we took care of a win in place and actually I should probably go with show in place, because this would be the ideal situation for a spread trader and happens rarely.

If you put on the spread and again, will buy July Wheat and we'll sell December Wheat at that 285 and 295, for a 10 cent differential. Buying July Wheat 10 cents under December Wheat, we don't care what the prices are. We're just buying at 10 cents under. This could be 385 and 395, it could be 1,085 and 1,095. It's the 10 cent differential that we're concerned with. But we buy 1 contract, we sell the other contract.

Now, the best situation that can happen to us is that our long position increases in value and our short position decreases in value. This is the win win situation. This is when you get absolutely lucky and you find the four leaf clover. We can look at the same- we have a lot less movement. Let's say that July Wheat went from 285 to 287. We're only looking at a 2 cent move. It's $100.00, that beats a sharp stick in the eye. It's a very small move for Wheat.

Now, if we look at our December contract in this case drops from 295 down to 292. We picked up 3 cents on that short, $150.00. In this situation, we win win.

Lan: Both contracts win, so we win both contracts.

Scott: Right, so we make 5 cents, which the spread moved greater than either of the underlying markets. That can happen.

Lan: The nice thing about spreads, that you're showing us here, is that the risk is significantly reduced. Even if one of your contracts loses money, you can still make money in a spread because the other one made more money than the one that you lost. That's the example, and then of course if both contracts make money, then you get the profit from both contracts. So, it's a win win situation, both ways.

Scott: Yeah, and you can really see the reduced risk in how the Futures industry accounts for spreading. We charge an initial margin, this is how much money you have to get into a contract. Initial margin is a function of risk. The more volatile a contract is, the higher the margin is. The lower the margin, the less volatile the less risk is inherent in that market. Typically within spreads, you get a margin break. There is risk in spreads, there's never, now there is- as you saw in two out of the three examples an outright futures position would have made more money, had we guessed correctly.

Lan: But the nice thing about that too, is we can guess incorrectly and still show a profit.

Scott: Right, there's always risk and reward.

Lan: The optimal is we're always looking for that four leaf clover. We want both contracts going the direction that we select. But that's not always the case. One will go in the opposite direction, but yet, you can still make money. So long as the one that you chose to go up, or goes up or down further than the other one you chose.

Scott: Exactly, one outperforms the other and that we're long outperforms the one that we're short. That doesn't always happen. There is risk involved in this. Let's look at- you know, we had the same- if prices go up and the one we're long increases in value more than the one we're short, we make money. If prices go down and the one we're long decreases in value less than the one we're short, we make money, or if prices go nuts and the one we're long goes up, we make money and the one we're short goes down, we make money and that's our four leaf clover.

We have the exact opposite in our risk side. It's possible for prices to go up and the one we're long increases in value less than the one we're short. Such as, in this example up here. Then we can go down to the next one, if we can see prices decrease and the one we are long decreases in value more than the one we are short.

Again, we could lose money, but you'll notice that the spread loss is less than either of the outright changes.

Lan: Because the outright change in our long, we lost $750.00 than the outright change in the short, we lost $500.00. But overall the spread, we only lost $250.00.

Scott: Exactly, and it's the same case when we underperformed to the upside. Now, just like we had the four leaf clover situation, we kind of- I'm not sure what's the exact opposite of a four leaf clover, but maybe the black cat walking under a ladder in front of us. Just as we can have upon occasion, the one we're long goes up and the one we're short goes down. That can happen to you in reverse- the one we're long goes down and the one we're short goes up.

Lan: Then, we have a combined loss on both contracts, and just the opposite of making all the money, we lose all the money.

Scott: Exactly, and in that situation- in fact, the spread has been more risk than the outright futures position. Which can be seen, we'll discuss later on within the video, and the seminar situation of how to choose spreads and how to look at which spreads, are terribly volatile and risky and which spreads you're looking at reducing your risk more.

Lan: Because there are exchange recognized spreads. They're spreads that the exchanges say these are the ones that you should be trading. For example: We don't go off and just match up anything that we haphazardly want to.

Scott: Yeah, we don't like the coffee Euro currency spread, probably not a wise one. Even sometimes, you know, within the markets if you understand the markets that you're trading. Some spreads that aren't as crazy as that situation can be terribly risky. We happen to pick a July December spread to show you here in the Wheat market, the July November spread in the Soybean market is a notoriously big moving spread and highly risky. That can be recognized at times, by the exchanges or your broker will not give you a break in margin for it. You will pay double margin, because you will pay a margin on your long position, and you will pay a margin on your short position.

Lan: It's the exchange recognized.

Scott: It's still exchanged recognized, but the exchange is recognizing that spread is saying it is risky. And it makes sense in that July soybeans represent, you know, and this is typically in the spring going into summer, the July soybean contract represents soybeans in storage. While the November soybean contract represents soybeans or it's called new crop represents soybeans that are growing in the ground right now.

Lan: So you have your old crop, new crop spread and they're spreading.

Scott: Exactly, and that can be a notoriously big moving spread in the soybean market which is volatile. I think I have to go back to 72 or 73 to see it to where the exchange said, "No, there is not any break given for margins at all." But I can sure remember within the last couple of years seeing the spread which normally trades about a third of the outright futures margin. So, let's say if the outright futures margin initial margin for soybeans were 1,000 I wouldn't be surprised to see the spread margin be $300.00. I've seen situations where that gets up to 50%-60% of it for July November Spreads.

That's kind of our introduction to spreads. Thanks for watching.

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