Spread Trading as a Strategy

Course 28 of 60 in the futures hub. Sometimes the view is that one contract is rich or cheap against another, and the broad market's direction is beside the point. This lesson treats the spread as the position: how it gets on, what the margin credit hides, and when the pair stops behaving like a pair.

When the outright is the wrong instrument

An outright is the wrong instrument when you don't want the market's direction in the ticket. You want the gap between two months, or between two related products. That gap is the position. The failure worth fearing is the other job people give spreads: burying an outright that's already losing, so the screen looks clever while the loss is still sitting there.

A spread is a view with a ratio on it, nothing more. People who get attached to one tend to skip the stop, and a slow loser is still a loser. Here both legs are futures, and both can still hurt you on the same morning.

1. Outright versus spread

An outright is one root and one month. You're long or short the market, the journal is a single line, and the dollar risk is the full move. A spread puts two legs on because the gap between them is what you wanted. Flatten one leg and keep 'managing' the other, and you have changed trades. Write that down the minute it happens, because the statement won't label the change for you.

One line, before you transmit anything: which leg is long, which leg is short, and what move in the spread proves the view wrong. If that line is blank, the diagram's warning is already true. You were going to sort the hedge out later, and later is an outright you're holding right now.

2. Listed spreads versus legging the two sides

A listed spread, the exchange's own quote for the pair, puts both legs on together at one spread price. Legging fills one side and works the other afterward. Between those fills you're outright the leg you already have, which is the position the spread was supposed to keep you out of. On a fast morning that gap between fills is long enough to matter.

Residual cap $198. The worst leg is still $10 a tick. 19 times $10 = $190, and $198 minus $190 leaves $8, so 19 ticks fit. The 20th tick is 20 times $10 = $200, which is past the cap. Size that ugly leg first.

Whether 19 ticks is a quiet hour or five minutes depends on your market. If the plan needs more room than that on the ugly leg, cut the size until the stop fits, or skip it. The contract size calculator rounds down, which is the way you want it to round. Do the ugly leg before you admire the margin credit on the pair.

3. Margin credit on a normal day

Clearing houses often post a lower margin on a recognized spread, because on an ordinary day the legs offset. People read the credit as permission to double up. The credit is a comment about typical offsets. It says nothing about the morning the ratio breaks and the account is suddenly responsible for something close to two outright risks.

Size from the residual loss you already wrote in dollars, at the point where the ratio is wrong. If you can't compute that loss, you don't know the trade yet. The margin screen can look kind right up until the offset fails. A low margin number is the clearing house's rule, not a measure of your risk. The residual is what goes in the journal.

4. When the spread runs one way

An honest residual is small beside either leg alone. When the relationship breaks, the profit and loss starts to look like two separate trades, and an event day can gap both of them the wrong way. Spreads don't get a pass on report mornings; the scheduled-reports lesson has the dates.

Write a single spread price that means get out, and write it while both legs are calm. Watching the legs to see which one saves you is how a one-way move becomes a hold you never sized. The diagram's last box is that day: both legs against you, and no offset left to point at.

5. Journal the residual

Record the spread price at entry and the spread price now. Record the dollar loss if price reaches the level that proves the view wrong. If the journal tells each leg's story and never writes down the gap, a broken ratio can hide in there for a week. The statement will show two lines. Your note has to show one position.

Which pairs get a spread credit, and how big it is, changes. Look up the current spread margin for the exact pair on the day you trade it.

6. Where spread trades go wrong

Putting a spread on to hide a loser you won't close. Legging into a number and getting stuck outright. Adding contracts because the margin looked small. Letting the spread run one direction for weeks on the theory that it has to come back, with no price that ends the try.

A hedge is a different job. You already hold something, and you want less of that risk. The hedging lesson takes that job. If what you actually have is an opinion that one contract is rich against another, keep the trade here and size the residual.

Spread margin is priced for normal days

The cheaper margin on a spread is a price for days when the legs behave. On the day they split, the discount does nothing for the loss. You can be inside the house's margin requirement and still be down more than the residual you thought you signed up for, because the residual changed shape under you.

Watch the spread as its own price, day after day. A spread that travels only one way for weeks is the relationship telling you it moved.

Before you put on a spread

• Write the residual first: long leg, short leg, and the spread move that proves you wrong.
• A $10 leg against a $198 cap fits 19 ticks ($190) and breaks on the 20th tick ($200).
• A lower spread margin describes an ordinary day. Read the risk off the residual dollars.
• Prefer the listed spread quote. Between two legged fills you're outright.
• A spread that has run one way for weeks is news about the relationship, not a cue to add.

If the second leg exists only so you can avoid looking at the original loser, close the loser and drop the extra leg. Educational only. Not a recommendation to buy, sell, or hold any contract or pair.