Spread Trading

The whole unit on one sheet: what a spread is, how it is quoted and filled, and what determines whether it profits.

What Is a Spread and How Is It Quoted?

• A spread is a long position in one contract and a short position in a related contract, held simultaneously, not a single directional bet. The two contracts are usually the same commodity in two delivery months, or two related commodities.
• Broad moves push both legs the same way and largely cancel, leaving the trader exposed to the gap between the two prices.
• A spread is quoted as the price differential, not two separate outright prices. Deferred at 445 minus nearby at 420 is a 25 differential.
• In futures, a spread is also called a straddle, a different position from the options straddle (a call plus a put at the same strike).

How Does a Spread Order Fill, and Why Does Margin Drop?

• A spread is placed as one order that fills both legs simultaneously at the specified differential, eliminating legging risk (execution risk): one leg filling at the wanted price while the other fills at a worse price before the position is complete.
• Legging in means entering the two legs as separate market orders, one at a time. Until the second fills, the trader holds a naked outright position.
• A spread generally requires less margin than the two outrights would cost separately, because the offsetting legs cut the position's net risk.

What Does the Spread Actually Profit From?

• The spreader profits from a change in the price difference, not from the outright direction of either leg.
• The one invariant: a spread profits when the long leg outperforms the short leg, rising more, or falling less, than the short leg, whether the gap is expected to widen or narrow.
• Because the legs offset, a spread is generally lower risk and lower reward than an outright position, not equal upside with less risk.
• A trader can be right about the differential and wrong about market direction and still profit on the gap alone.

How Do Widening, Narrowing, and Market Structure Set the Legs?

• To profit from a widening gap: be long the leg expected to gain and short the other leg. To profit from a narrowing gap: be long the leg expected to gain as prices converge and short the leg expected to give ground.
• Normal market: deferred priced above nearby, reflecting carrying charges (storage, insurance, interest). Inverted market: nearby priced above deferred, from a supply shortage in the nearby.
• Market structure tells the trader which leg to make long and which short so the expected change in the differential pays off.

Which Gotchas Trip Students Up?

• "The market went up, so the spread made money" skips the real question: did the gap move the trader's way? Outright direction can go against the trader while the spread still profits.
• A spread order fills both legs together in one order, not two market orders back to back; legging in puts the execution risk back.
• Spread margin is lower than the sum of the two outright requirements, not the total of both.
• A narrowing gap in a normal market means long the nearby and short the deferred, not "sell the spread and hope." An inverted market is not broken; nearby over deferred is the expected result of tight nearby supply.

One-Breath Recap

A spread is a long position in one futures contract and a short in a related one held at the same time, quoted and filled as a single price differential rather than as two outright prices, so a single spread order eliminates legging risk and earns lower margin than two separate outright positions; the spreader profits from a change in that differential, not from market direction, under the one invariant that the long leg must outperform the short leg, whether the trader is positioned for the gap to widen or to narrow, and the normal market (deferred over nearby, reflecting carrying charges) versus the inverted market (nearby over deferred, from a supply shortage) tells the trader which leg to make long and which to make short.

Need more than the recap? Read the full Spread Trading unit.