Spread Trading Futures vs FX
Futures In Futures Spread Trading the trader simultaneously buys (longs) and sells (shorts) futures contracts for two related commodities or securities. The rationale behind this kind of strategy is that as futures contracts approach maturity, prices of different contacts will often change differently over time, leaving savvy traders an opportunity to profit. We explain this in more detail below, but overall spread trading offers good traders the opportunity to profit off contract spreads instead of taking a position on the market direction.
Some traders may also pursue this kind of trade, believing they reduce their overall exposure to the market, since losses from longs will be offset from shorts and vice-versa. Futures spread trading generally is a more conservative approach to trading overall than simply investing in one futures contract.
FX In FX, spreads traders seek to buy a currency cross in order to take advantage of rollover interest, while simultaneously shorting a similar pair to reduce their exposure to unpredictable fluctuations in price.
Why Opportunities Exist in Futures Spread Trading
Opportunities for spread trading exist for a number of reasons. Spreads may change due to seasonality, backwardation theory and other factors that lead the market to think one contract will be more affected than another for the same commodity. Examples may come from agricultural commodities where harvest month contracts tend to have more supply on the market, pressuring prices down â€“ and from bond markets where contracts that expire before April tend to demand a different price than the same bond contract set to mature after taxes are due.
Inter-commodity and Inter-market spreads tend to trend more than the outright commodity price. Even as commodity prices remain flat, spreads still often trend in one direction. Such consistency in trend is attractive to traders looking for positions that require what they think is less exposure to the market. Lastly because spread positions tend to offset each other, and because they tend to earn brokerages extra commissions for additional positions in the market, brokers will tend to have low margin requirements for spread trades.
Issues and Disadvantages of This Sort of Strategy
There are some problems associated with trying to create a spread with the currency market however. In futures spread trading, a trader makes equal purchases on similar securities/commodities with different maturity dates. However, in FX you are making purchases on what amounts to completely different underlying assets.
Using the example above, even though the trader has made equal bids on both the GBP/JPY and the CHF/JPY position, she still has not perfectly reduced her exposure to the market. The current exchange rate between the GBP and CHF is at 2.35; a Pound will buy 2.35 Swiss Francs. This means that the 100,000 francs he has shorted in the opening position are only worth approximately 42,000 pounds. Thus, this is an imperfect hedge as the 100,000 francs the trader has shorted to limit his Pounds market exposure are only covered by half. In other words, if she decides not to long 100,000 francs in the next round, the trader is still only covering 42,000 out of the 100,000 Pounds he has purchased.
Now, let assume the trader did create a position equal to the GBP/JPY with the CHF/JPY position. This would mean that she longs 100,000 Pounds in GBPJPY and shorts approximately 240,000 Francs in CHF/JPY. Here she has synthetically created a 100,000 GBP/CHF position. But since those positions were opened through JPY pairs the trader would have paid extra spread to open the position. When compared to a straight GBP/CHF trade the traders has paid the spread on the GBP/JPY and the CHF/JPY position â€“ for essentially the same position.
Traders are at a loss to find a perfect hedging or spread play.
Many traders set up hedged positions or triangular cross spread positions in the belief that they have found a way to achieve interest rate arbitrage while mitigating exposure to foreign exchange fluctuations. However traders should take the short time required to check the mathematical rationale behind their trade. Often there is a more direct trade they can make that saves added spread â€“ although it probably won look quite as impressive in the open positions window.
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