A spread is a basic trading strategy in which a trader buys and sells two contracts, one each of a different but complementary financial instruments. This trade is designed to allow the trader to potentially benefit from the difference in price between the two financial instruments.
Using Seasonality to Build a Spread Strategy
Seasonality could potentially be used as the basis for a complementary relation between the two financial instruments. For example, using seasonality as the basis, heating oil futures (UHO) and gasoline (RB) could be traded using a spread. If the spread were purchased during the spring/summer months, a trader could buy one gasoline (RB) and sell one heating oil (UHO) contract. A potential exit strategy could be to sell the spread at the end of summer or beginning of fall.
Below is a chart comparing a heating oil (UHO) and gasoline (RB) futures contract:
Using Different Index Futures to Build a Spread Strategy
Different equity index futures contracts could potentially be used as the complementary relation between two financial instruments. For example, using different indexes as the basis, the S&P 500 Index (ES) and Nasdaq Index (NQ) could be traded using a spread. If the spread were purchased simultaneously, a trader could buy one S&P 500 (ES) and sell one Nasdaq (NQ) contract.
The idea behind buying one index while simultaneously selling another in a spread is to capture the momentum of an index moving or having the potential to move at a high rate. Taking the opposite position with a second contract of a different index is meant to act as a hedge or safety net. This index futures trading strategy spread will potentially allow you to benefit from the strong momentum of one index while protecting against a reversal or slow down in momentum of the initial contract. A potential exit strategy could be to set a ‘trailing stop’ with your automated trading software to execute simultaneous sell and buy orders counter to your existing positions in the spread.
When trading a spread strategy, it is important to note the risk if the spread moves against your position. Always keep in mind that implementing a spread strategy does not assure a beneficial trade. As with any trading strategy, spread strategies involve risk that has to be managed. Additionally, as you would be opening a secondary trade to complete the spread, commissions and fees would apply to this trade as well.
Below is a chart comparing a S&P 500 (ES) and Nasdaq (NQ) futures contract: