Futures spread

What Is Futures Spread?

A futures spread is a derivatives trading strategy that involves simultaneously buying and selling two different, but related, futures contracts. This financial instrument is primarily used by traders and investors to profit from the expected change in the price differential, rather than the outright price movement, of the underlying assets. Futures spreads are a fundamental concept within financial markets, allowing participants to take positions on the relationship between prices, often aiming to reduce the directional risk associated with holding a single futures contract. This strategy can be applied across various commodities, financial instruments, or different delivery months for the same commodity.

History and Origin

The concept of futures trading emerged centuries ago to manage agricultural price risk, with formal exchanges appearing in the mid-19th century. The Chicago Board of Trade (CBOT), established in 1848, was instrumental in introducing standardized contracts for future delivery, helping to stabilize agricultural markets. Early on, participants recognized that the price relationships between different delivery months or related commodities held valuable information and opportunities. The formalization of futures spreads as distinct trading strategies evolved as markets became more sophisticated and liquid. Federal oversight of futures trading began with early legislation, leading to the establishment of the Commodity Futures Trading Commission (CFTC) in 1974. This independent agency was created to provide comprehensive oversight of the rapidly evolving futures markets, which had expanded beyond agricultural commodities to include a wide array of financial instruments⁵.

Key Takeaways

• A futures spread involves simultaneously buying and selling two related futures contracts.
• The strategy aims to profit from changes in the price difference between the two contracts, not their absolute price movements.
• Futures spreads can be less volatile and carry lower margin requirements compared to outright futures positions.
• Common types include calendar spreads (different delivery months), inter-commodity spreads (different but related commodities), and inter-market spreads (same commodity on different exchanges).
• They are often employed for hedging, speculation, or arbitrage based on perceived mispricings or anticipated shifts in supply and demand dynamics.

Formula and Calculation

The calculation of a futures spread is straightforward, representing the difference between the prices of the two futures contracts involved. For a simple calendar futures spread, where a trader buys one contract and sells another of the same underlying asset but with a different expiration date, the formula is:

Where:

• (\text{Long Contract Futures Price}) is the price of the futures contract that is bought.
• (\text{Short Contract Futures Price}) is the price of the futures contract that is sold.

For example, if a trader buys a December crude oil futures contract and sells a September crude oil futures contract, the spread is the December price minus the September price. This formula allows traders to track the performance of the spread itself, independent of the directional movement of crude oil's overall spot price.

Interpreting the Futures Spread

Interpreting a futures spread involves understanding the market's expectations regarding future supply and demand conditions and carrying costs. A positive spread (where the deferred contract is priced higher than the nearby contract) is typical in a contango market, indicating that storage costs, interest rates, and insurance are factored into the future price. This is common in commodity markets where holding the physical asset incurs costs. Conversely, a negative spread, where the nearby contract is more expensive than the deferred contract, is characteristic of a backwardation market. This often signals current scarcity or high demand for immediate delivery of the underlying commodity. Traders interpret changes in the spread to anticipate shifts in market fundamentals or to identify potential trading opportunities based on their view of whether the current relationship is sustainable or likely to widen or narrow.

Hypothetical Example

Consider an energy trader who believes that the current wide spread between crude oil futures contracts for July and September delivery will narrow.

1. Current Market Prices: July crude oil futures are trading at $80.00 per barrel, and September crude oil futures are trading at $81.50 per barrel. The current futures spread (September - July) is $1.50.
2. Trader's Action: The trader executes a futures spread by simultaneously buying one July crude oil futures contract and selling one September crude oil futures contract. This is a "bear spread" if the nearby (July) is expected to gain relative to the deferred (September), or more simply, a bet that the existing contango will narrow.
3. Market Movement: A few weeks later, due to unexpected supply disruptions, the July crude oil futures price rises to $82.00, and the September crude oil futures price rises to $82.50.
4. Closing the Position: The trader closes the futures spread by selling the July contract and buying back the September contract.
   • July contract profit: ($82.00 - $80.00) = +$2.00
   • September contract loss: ($82.50 - $81.50) = -$1.00
   • Net profit from the spread: +$2.00 - $1.00 = +$1.00 per barrel.

In this example, the outright prices of both contracts increased, but the trader profited from the narrowing of the spread from $1.50 to $0.50 ($82.50 - $82.00). This illustrates how a futures spread allows a trader to profit from the relationship between prices, rather than needing to predict the direction of the underlying asset's price.

Practical Applications

Futures spreads are versatile tools used across various facets of finance and investing. In active trading, traders utilize them for speculation, capitalizing on anticipated changes in the price difference between contracts. For instance, a trader might execute a futures spread if they expect the difference between short-term and long-term interest rates to widen or narrow, trading interest rate futures.

Beyond speculative endeavors, futures spreads are critical for hedging activities. Commercial entities, such as airlines hedging fuel costs or agricultural producers hedging crop prices, use futures spreads to lock in price relationships rather than absolute prices. This can protect against adverse movements in a particular commodity's price while maintaining flexibility regarding future inventory or production. For example, a refiner might buy crude oil futures and sell gasoline futures to hedge the crack spread, which represents the refining margin.

Regulatory bodies also monitor the broad derivatives market, which includes futures spreads, for signs of systemic risk. The U.S. Securities and Exchange Commission (SEC) adopted new rules in 2020 (Rule 18f-4) to modernize the regulatory framework for how registered funds, including mutual funds and exchange-traded funds (ETFs), use derivatives. This rule aims to provide a comprehensive approach to managing derivatives risk and enhancing investor protections⁴. Similarly, the Federal Reserve evaluates the potential impact of derivatives markets on overall financial stability and often highlights the importance of robust risk management practices within these markets³.

Limitations and Criticisms

While futures spreads can offer distinct advantages, they are not without limitations or criticisms. One primary concern is the complexity involved in analyzing and managing multiple positions simultaneously. While reducing directional risk, basis risk (the risk that the price relationship between the two contracts changes unexpectedly) remains a significant factor. Market events, such as the unprecedented negative pricing of West Texas Intermediate (WTI) crude oil futures in April 2020, highlight how extraordinary circumstances can disrupt established price relationships and spread dynamics². In this event, storage capacity issues for physical crude oil led to the May 2020 futures contract trading at negative prices, severely impacting traders who were unable to take delivery or find storage, regardless of their spread positions¹.

Furthermore, while margin requirements for futures spreads are typically lower than for outright futures, market volatility can still lead to significant margin calls if the spread moves adversely. Traders must understand the nuances of carry costs, storage capacity, and delivery obligations, especially in commodity futures spreads, as these factors can significantly influence spread behavior. While some view futures spreads as less risky, the leverage inherent in futures trading means that even small changes in the spread can result in substantial gains or losses if not properly managed.

Futures Spread vs. Options Spread

Futures spreads and options spreads are both strategies involving simultaneous long and short positions in related derivatives, but they differ fundamentally in their structure and risk-reward profiles.

The primary confusion between the two arises from their shared goal of profiting from relative price movements rather than absolute ones. However, a futures spread creates a direct obligation to deliver or receive the underlying asset, leading to a more linear profit and loss experience. An options spread, conversely, involves buying and selling different strike prices or expiration dates of options, where the value is derived from the right, not the obligation, to trade the underlying. This gives options spreads a defined risk and reward, whereas futures spreads carry potentially unlimited profit or loss, albeit on the differential.

FAQs

What is the main purpose of a futures spread?

The main purpose of a futures spread is to profit from a change in the price difference between two related futures contracts, rather than predicting the outright direction of the underlying asset's price. This can reduce directional risk and often requires lower margin compared to a single futures position.

Are futures spreads less risky than outright futures contracts?

Futures spreads are generally considered less risky than taking an outright position in a single futures contract because they reduce directional price risk. However, they are still exposed to basis risk—the risk that the difference between the two contract prices changes in an unfavorable way. They also involve leverage and can still result in substantial losses.

What is a calendar spread in futures?

A calendar spread, also known as an intra-market spread, is a type of futures spread that involves simultaneously buying and selling two futures contracts on the same underlying asset but with different expiration months. For example, buying a December crude oil contract and selling a September crude oil contract. This strategy is used to profit from changes in the price relationship between different delivery periods.

Can futures spreads be used for hedging?

Yes, futures spreads are widely used for hedging. Businesses and producers can use them to lock in a specific processing margin or to hedge against unexpected changes in the price relationship between an input commodity and its refined product, effectively managing commodity price risk.