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Smarter trading in futures spreads

Ian Mawdsley
Ian Mawdsley
Head of Equities, EMEA, Refinitiv

Futures spread trading is a tried-and-trusted strategy that’s evolving through technology. How are vendor-supplied spread trading solutions, such as Refinitiv’s REDI, creating highly customized spreads to help maximize flexibility and minimize execution risk?

  1. New technologies have brought futures spread trading to the forefront as an alternative trading strategy.
  2. Vendor-supplied spread trading solutions, such as REDI, provide the flexibility, utility and speed needed for cross-exchange and inter-product trading of futures.
  3. A powerful user interface can create highly customized spreads to help traders maximize spread capture and minimize execution risk.

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While you may not be able to teach an old dog new tricks, you can still benefit from old tricks — such as those tried and trusted trading strategies that have been around almost as long as the exchanges themselves.

Take futures spreads, a classic way to both increase profits and decrease risk. Add new, more tech-savvy ways to develop and execute strategies, and there’s something worth evaluating as an alternative to your current approach.

Advantages of futures spread trading

Futures are a tool traders can use to manage price risk of an underlying commodity or financial position.

Traders with a physical position in a commodity (for example, crude in storage) can use the futures markets to hedge, creating a degree of certainty by locking in the price of selling the position in the future, such as for delivery to a client.

For traders without a physical position, trading outright futures can be risky, subjecting them to the volatility of the underlying instrument. Futures spread trading mitigates some of that risk by shifting the focus to the movement between related positions.

For example, in energy trading, going long diesel and short gasoline insulates the trader from much of the volatility, or systematic risk, in the underlying oil markets, reducing the bet to a view where diesel prices gain more relative to gasoline prices, regardless of whether the price of both goes up or down.

As it’s typically less risky, spreads are also cheaper, requiring only a fraction of the margin payments than outright futures trades.

Order book pricing

Futures spread trading is a powerful tool and brilliant in its simplicity.

It requires taking two positions simultaneously in order to benefit, or more specifically, profit from the relative price change. The two positions are traded as a single unit with each position serving as a leg of the unit trade.

A successful spread analysis considers the price direction — whether the spread is narrowing or widening.

With order book pricing, participants enter resting orders in the spread product in the same way as an outright maturity. Implied pricing involves the exchange synthetically creating a spread price by calculating off the prices available in the outright products.

Types of spreads

Spreads can be used to take advantage of the convergence or divergence of the prices of the underlying products. The goal is for the long or short to outperform the other with minimal risk. Different types of spreads include:

  • Calendar spreads: These are the most common and involve the simultaneous entry of a buy and sell of different futures maturities. The price is the difference between the two products. These can extend the life of an outright futures position. For example, a portfolio of German stocks may offset with a short position in DAX Futures. When the futures position is due to expire, the trader may roll the position to cover the short in the current month and create a new short in the next maturity.
  • User-defined spreads: The user requests that the exchange create the spread product in the database and then request market participants to provide a price and volume in order to trade. This tends to happen more with options on futures rather than futures themselves. As these require a direct connection to the exchange, only ISV or exchange-owned platforms have the ability to create user-defined spreads. Illiquid or rarely used spread combinations are either never created or deleted to save storage space.
  • Inter-commodity/inter-exchange spreads: These allow differential trade between uncorrelated instruments. A number of these are available on exchanges for commodity products in particular spreads, such as the Soybean Crush spread and Crack spreads for oil and gas products. Inter-commodity spreads tend to trade as Central Limit Order Book and do not benefit from implied prices from the outright leg components, even where an exchange supports them. This makes the amount of available liquidity very minimal.

Benefits and risks of futures spread

Choosing two products to sell accurately requires either low latency access or a high level of flexibility on how and where to execute order. Futures spread trading gives users greater flexibility. Here are some advantages:

  • Create any number of intra- and inter-commodity spread products.
  • Support inter-exchange product trading.
  • Trade across asset classes, e.g., bonds vs. bond futures.
  • Gain greater control over how and when to execute legs of spreads.
  • Increase liquidity with implied pricing.
  • Hide the spread from the market by seemingly executing two separate leg orders.

But nothing is perfect. It’s important to recognize the limitations of non-exchange supported spread trading, including an increased risk of getting “legged”.

Moreover, traditional spread tools tend to be built into the front-end of a trading platform — the least optimal point of execution. In an ideal world, the ‘decision’ hub would be right next to the exchange entry point. But it’s expensive.

The optimal design would be a client server set-up, allowing users to define trading parameters but still have the vendor manage it in a high-powered cloud-hosted server.

That’s the beauty of vendor-supplied spread trading solutions, such as REDI Spread Trader. You gain the flexibility, utility and speed needed for cross-exchange and inter-product trading of futures — all on a single platform.

With a powerful-yet-simple user interface, you can create highly customized spreads to help you maximize spread capture and minimize execution risk.

While your goal is to trade at lower risk, you wouldn’t be in this business if you’re weren’t prepared to take some risk. By recognizing these limitations and having the right vendor trading tool in place to help you navigate these potential pitfalls, the benefits outweigh the risks.

© Refinitiv 2019. All Rights Reserved.

REDI Global Technologies LLC is a member of FINRA/SIPC. REDI Technologies Ltd. is authorized and regulated by the UK Financial Conduct Authority. This communication is only intended for institutional customers and eligible counterparties as defined by the respective regulators/authorities. REDI services and related services are not available in all jurisdictions.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Refinitiv, or any of its respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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What are future spreads?

Futures spread trading is a tried-and-trusted strategy that's evolving through technology. Spreads can be used to take advantage of the convergence or divergence of the prices of the underlying products. The goal is for the long or short to outperform the other with minimal risk.