Understanding Futures Spread Trading | by LBank Exchange | Aug, 2023

From the LBank blog.

Understanding Futures Spread Trading

Futures contracts have a long history spanning hundreds of years, and futures spread trading has been a part of futures trading since its inception. However, this trading strategy remains relatively unknown to most retail traders, and even fewer truly understand the benefits it offers. While traditional traders often employ spreads for hedging and capitalizing on price variances between specific contract futures, speculators can also utilize these techniques to their advantage. In cryptocurrency, futures spread trading is a type of market-neutral strategy that traders explore to benefit from the change in price differences.

This article aims to introduce you to the fundamentals of future spread trading, providing a comprehensive overview of its concepts, benefits, and strategies.

A spread, in the context of trading, involves simultaneously purchasing one futures contract while selling another, with the intention of profiting from the price differential between the two contracts. This strategy serves various purposes, including rolling open positions forward to avoid expiration, hedging against price fluctuations, and capitalizing on directional price movements or mean reversion patterns.

The price of each futures contract is determined by the market, influenced by traders’ market positions and analysis of the asset’s potential price, coupled with the projected costs of holding the asset until that time. Since these contracts are traded on distinct markets with varying levels of liquidity, their price volatility can diverge, leading to fluctuations in the price differentials between the contracts.

There are two main categories of spreads: intra-market spreads and inter-market spreads. Intra-market spreads involve positions within a single futures market, such as different contract months for a specific commodity. Inter-market spreads, on the other hand, span multiple markets and can involve different commodities or even financial instruments like interest rates.

Two essential terms to grasp in futures spread trading are contango and backwardation. These terms refer to the shape of the forward price curve for a commodity. Contango occurs when near-month futures contracts are cheaper than those expiring further out, usually due to costs associated with storage and carrying the physical commodity. Backwardation, conversely, emerges when near-month contracts are more expensive, often reflecting supply-demand imbalances.

To better understand the concept of futures spreads, consider this example.

In February, with BTC priced at 18,000 USDT, a trader buys the April BTC future at 19,000 USDT and simultaneously sells the May BTC future at 19,300 USDT. The difference between the two prices, or the spread, is 300 USDT. Using the futures spread strategy, the trader has three options:

  1. Wait and Profit: One choice is to wait for both contracts to conclude, profiting from the initially entered spread. If they buy BTC at 21,000 USDT in March and then sell it a month later for 19,300 USDT, they’ll make 300 USDT regardless of the spot price at settlement. This is a good move if the spread remains steady or narrows, and their account holds enough margin for the second leg.
  2. Amplify Profits: Alternatively, they can close positions for even higher earnings if the spread widens before settlement. If the near-term contract price holds while the longer-term one climbs to 20,000 USDT, closing the positions nets them an additional 700 USDT, summing up to 1,000 USDT. This strategy is best when the gap between near- and longer-term contracts broadens.
  3. Rollover: A different approach is to roll over the spread at the near-term contract’s settlement date. By closing the near-term contract and opening an opposing futures position for the longer-term contract, they extend the futures spread trade with a new settlement date.

Spread trading offers several advantages that can enhance a trader’s risk management and profitability:

  1. Reduced Price Volatility Risk: Spreads often exhibit lower price volatility compared to individual contracts, leading to more stable trading conditions and reduced risk exposure.
  2. Lower Margin Requirements: Trading spreads typically require lower margin requirements than trading individual contracts, allowing traders to control larger positions with less capital.
  3. Directional and Mean Reversion Strategies: Traders can capitalize on both directional price movements and mean reversion patterns using spread trading, broadening their range of profitable strategies.

Although futures spread trading offers a means to minimize various risks linked to individual market positions, it’s imperative to acknowledge that it isn’t exempt from potential drawbacks. Nonetheless, by exercising prudent oversight, these risks can be notably curtailed.

A crucial risk to bear in mind is leverage, a factor that introduces the possibility of liquidation. Engaging in leveraged trading amplifies both your gains and losses, underscoring the need for cautious navigation. Failure of a trade to fulfill the margin prerequisites of a leveraged transaction could trigger automatic partial or complete liquidation of your spread position.

Futures spread trading offers a world of opportunities for traders, both experienced and novice. Understanding the basics of spread trading, the benefits it brings, and the tools at your disposal, you can unlock a dynamic trading strategy that complements your existing approach. However, it’s essential to note that this strategy isn’t without risk. As such, it is important to employ effective risk management strategies and always conduct your own research.

Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.

This article came directly from the LBank blog, found on https://lbank-exchange.medium.com/understanding-futures-spread-trading-2a65b58fdf2a?source=rss-87c24ae35186——2

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