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Is spread trading the most profitable way to trade futures?

Updated on 2012-09-11 by MikeMM

Spread trading refers to the practice of selling (going short) one or more futures contracts while simultaneously buying (going long) one or more offsetting futures contracts with the intention of capitalizing on a possible discrepancy in prices. Spread trading the futures market is an important trading technique that is increasingly gaining significance throughout the world. Traders who use this technique, sometimes called “Spreaders”, find it to be a good way of navigating the futures market while effectively managing their risk. The great benefits of futures spread trading make it the ideal investment of choice for both experienced and novice traders.

Here are some reasons why spread trading is considered to be the most profitable way of trading futures:

Spreads have lower risk

Spread trading is regarded to be one of the most conservative methods of navigating the futures market. Trading using this strategy is less risky than the trading of outright (naked) futures contracts. Particularly, since it entails entering both sell and buy positions in the market, traders using this strategy have nearly hedged down their downside risk.

Spreads have reduced margin requirements

The majority of brokers provide lower margin requirements for those who wish to engage in trading futures spreads. As such, it enables traders to place more positions in their trading accounts even if they have limited capital. For instance, the margin on naked futures position in corn could be $550. However, placing a spread trade in the same commodity would require only $140, which is about 25% as much. This is a great edge for traders having limited capital. If you have a capital of $10,000 in your trading account and you risk eight percent of your account, you can enter up to six corn spreads. Is this comparable with 1-2 outright corn futures trades you can enter using the same amount of capital?

Spreads do not need a lot of time

Engaging in trading futures spreads does not oblige you to watch the market movements all day long. To place and exit trades using spread trading technique does not need access to live market data. In fact, the recommended way of trading spreads is through analyzing the data at the end of the day. Thus, spread trading is a good alternative if you are not able to stay glued to your computer screen all day long because of some other important issues you need to handle.

Spreads shield you from running stops

The absence of stops in futures spread trading prevents you from being a victim of stop fishing. Since your positions are not visible to the market movers and the market makers, they are unable to possibly run your stops. Although spreads have places for exit, entering a stop order is practically not a possibility. Thus, since it prevents malpractices, spread trading is regarded to be a more pure form of navigating the futures market.

Spreads increase avenues of profit

Whereas selling or buying futures contracts outright only provides you the opportunity of getting profits when your trade goes according to your expectations, futures spreads provides profit opportunities through the price difference of the buy and sell leg rather than the price action of the underlying itself. More over, spreads are capable of increasing the avenues of profit because they are less volatile (when matched against simple contracts), easy to forecast, and normally follow well-established trends.
Worth mentioning, trends in futures spreads do not take place because of market manipulation; they are not formed because of the interference caused by market movers and market makers. Futures spreads form trends because of pure price action taking place in the underlying asset.

Spreads offer a higher return on margin

Every point in spread futures has the same value as every point in outright futures; however, it offers a better return on margin because the margin on spread futures is much lower. For example, if every point in spread futures is valued at $40 and every point in outright futures is valued at $40, then for a 4-point move in the right direction in corn futures or a 4-point move in the right direction in the spread could earn you $160. However, there is a big difference in return on margin:
• Corn futures- $160/$550 = 29.9% return
Note that $550 is the margin as per the earlier example
• Corn spreads - $160/$140 = 114.2% return
Note that $140 is the margin as per the earlier example

This example clearly illustrates that you can achieve a higher return on your margin using spread futures. Therefore, this gives you a big advantage if you’re engaging in spread trading.

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Trading financial instruments, including foreign exchange on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in financial instruments or foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.