One of the best kept secrets in trading is that of reduced margin spreads. You cannot name a trading method that provides more safety or a greater return on margin than does a reduced margin spread, while also being one of the least time-consuming ways to trade. Have you ever asked yourself why it is that many of the largest, most powerful traders trade spreads? I’m going to show you why!
What is a reduced margin spread?
Because of perceived lower volatility, exchanges grant reduced margins on certain types of spreads. Spreads consist of being long in one or more contracts of one market and short in one or more contracts of the same market but in different months—an intramarket spread; or being long in one or more contracts of one market and short one or more contracts of a different market, and in the same or different months—an intermarket spread.
Distortions about spreads
There are some distortions about spread trading that need to be dispelled. If we get them out of the way, I can show you the tremendous advantages spread trading has over any other form of trading.
It is said that spreads do not move as much as outright futures. I agree 100% with that statement. However, spreads trend much more often than outright futures, they trend much more dramatically than outright futures, and they trend for longer periods of time than do the outright futures. For these reasons you can make much more money with spreads than with the outrights.
The second distortion about spread trading goes like this: “You have to pay double commissions when you trade spreads.” Yes! You have to pay two commissions for every spread you enter in the market. So what? You are trading two contracts instead of one. You pay two commissions because you are trading two separate contracts, one in one place and the other in an entirely different place. Paying two commissions for two separate trades is hardly unfair. Let me tell you what is unfair—paying a round turn commission for an option that expires worthless. Why don’t you hear people complaining about that? You pay for a round turn, and you receive only half a turn. Doesn’t make a lot of sense, does it?
Advantages of Spread Trading
There are so many advantages to trading reduced margin spreads that I hope I don’t run out of room here before I can tell you all of them. Let’s begin with return on margin, i.e., yield.
Yield: As I write this, the margin to trade an outright futures position in crude oil is $4,725, whereas a spread trade in crude oil requires only $540, only 11.4% as much. If crude oil futures move one full point, that move is worth $1,000. If a crude oil spread moves one full point, that move is worth $1,000. That means either a 1 point favorable move in crude oil futures or a 1 point favorable move in a crude oil spread earns the trader $1,000. However, the difference in return on margin is extraordinary: In the futures the return is $1,000/$4,725=21%. For the spread, the return is $1000/540=185%. Think about that!
Leverage: This leads us to the next benefit of spread trading—with the same amount of margin, you could have traded 4 soybean spreads instead of one soybean futures. How’s that for leverage? Instead of making $250 on a five point move, you could have made $1,000. Reduced margin spreads offer a much more efficient use of your margin money.
Trend: Earlier I said that spreads tend to trend much more dramatically than outright futures contracts. Not only that, but they trend more often than do outright futures. I don’t have room here to show you the dozens of sharply trending spreads that can regularly be found in the markets, so we’ll have to settle for a recent one. You’ll have to take my word for it that this sort of trending happens frequently when trading spreads.
What is a reduced margin spread?
Because of perceived lower volatility, exchanges grant reduced margins on certain types of spreads. Spreads consist of being long in one or more contracts of one market and short in one or more contracts of the same market but in different months—an intramarket spread; or being long in one or more contracts of one market and short one or more contracts of a different market, and in the same or different months—an intermarket spread.
Distortions about spreads
There are some distortions about spread trading that need to be dispelled. If we get them out of the way, I can show you the tremendous advantages spread trading has over any other form of trading.
It is said that spreads do not move as much as outright futures. I agree 100% with that statement. However, spreads trend much more often than outright futures, they trend much more dramatically than outright futures, and they trend for longer periods of time than do the outright futures. For these reasons you can make much more money with spreads than with the outrights.
The second distortion about spread trading goes like this: “You have to pay double commissions when you trade spreads.” Yes! You have to pay two commissions for every spread you enter in the market. So what? You are trading two contracts instead of one. You pay two commissions because you are trading two separate contracts, one in one place and the other in an entirely different place. Paying two commissions for two separate trades is hardly unfair. Let me tell you what is unfair—paying a round turn commission for an option that expires worthless. Why don’t you hear people complaining about that? You pay for a round turn, and you receive only half a turn. Doesn’t make a lot of sense, does it?
Advantages of Spread Trading
There are so many advantages to trading reduced margin spreads that I hope I don’t run out of room here before I can tell you all of them. Let’s begin with return on margin, i.e., yield.
Yield: As I write this, the margin to trade an outright futures position in crude oil is $4,725, whereas a spread trade in crude oil requires only $540, only 11.4% as much. If crude oil futures move one full point, that move is worth $1,000. If a crude oil spread moves one full point, that move is worth $1,000. That means either a 1 point favorable move in crude oil futures or a 1 point favorable move in a crude oil spread earns the trader $1,000. However, the difference in return on margin is extraordinary: In the futures the return is $1,000/$4,725=21%. For the spread, the return is $1000/540=185%. Think about that!
Leverage: This leads us to the next benefit of spread trading—with the same amount of margin, you could have traded 4 soybean spreads instead of one soybean futures. How’s that for leverage? Instead of making $250 on a five point move, you could have made $1,000. Reduced margin spreads offer a much more efficient use of your margin money.
Trend: Earlier I said that spreads tend to trend much more dramatically than outright futures contracts. Not only that, but they trend more often than do outright futures. I don’t have room here to show you the dozens of sharply trending spreads that can regularly be found in the markets, so we’ll have to settle for a recent one. You’ll have to take my word for it that this sort of trending happens frequently when trading spreads.
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