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What is a Futures Spread?

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  • Written By: Tim Zurick
  • Edited By: A. Joseph
  • Last Modified Date: 10 November 2016
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A futures spread is a combination of related futures positions, commonly referred to as legs. A single unspread — or outright — futures position makes or loses money as a commodity’s price rises and falls, but a spread is designed to make money based on the price relationship between a combination of positions. A futures spread usually consists of legs that are positively correlated, meaning that their prices tend to move together. They also might include legs that tend to move in opposition to each other. Futures spreads attempt to capitalize on price relationships while lowering risk.

An example of a futures spread based on positive correlation would be the purchase of contracts in both heating oil and unleaded gasoline. Both are derived from crude oil, and as a general rule, their prices move up and down together. A trader might determine, however, that heating oil inventories are lower than normal, and gasoline inventories are higher than normal. If he or she expects refiners to correct the imbalance by diverting more of their capacity toward production of heating oil and away from gasoline, the trader might buy a gasoline contract and sell heating oil. As inventories realign to their normal levels, the price of each leg should move in the trader’s favor.

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In general, such an inter-commodity futures spread is a less risky proposition than simply buying the gasoline alone or selling the heating oil alone. In the above example, if a hurricane shut down crude oil production, resulting in shortages of both heating oil and gasoline, both would tend to rise rapidly in price. A lone short leg in heating oil could be expected to lose big, but a spread that included a long gasoline leg might make up much, if not all, of the loss. The inventory differential would become a secondary factor, and the trader would be looking at a break-even trade rather than a massive loss.

A correlated futures spread usually entails less risk than an outright position, so futures exchanges normally offer a lower hedge margin to hold them. Correlations don’t always hold, though, and a spread can and occasionally does go just as badly as an outright position. Other possible futures spreads can be constructed by buying and selling different contact months of the same commodity based on varying seasonal tendencies. By adding various combinations of options to the related futures contracts, potential risk and reward can be fine-tuned to almost any taste.

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