Spreads

Spreads are strategies that involve buying one contract and selling another. You’ll come across them again in the next module, on options, but with futures they’re a little different from those. The term spreads comes from the price difference between the two contracts, and the object of spreads as a strategy is that the price difference between the two will change, as opposed to looking for an overall rise or fall in the underlying. It’s actually a lower risk and lower reward strategy — you can’t lose your shirt with a runaway price because the price on the other contract will move in the same direction, but to a slightly different extent if your spread strategies work.

To profit with spreads on futures, you need to figure out the relationship between the prices on the two contracts. Which one do you expect to move higher or lower relative to the other? The two contracts must be related, whether they are on the same underlying with different delivery dates, or on two different underlying stocks or commodities that tend to move in correlation to each other. By the way, just because they are correlated does not mean they move in the same direction. You can have two stocks that move in different directions, such as oil stocks and airline stocks, so when oil stocks rise airline stocks fall. These are said to be negatively correlated.

Most of the time you will find your broker needs a lower initial margin for your spread strategy, as he is not so exposed to losses. It’s not the same as having two totally different contracts, when he would want the full margin on each.

The spread strategy is usually to buy one contract and sell another, so that you establish a negative correlation. You use this when you expect the values to move in the same direction. For instance, you might buy a contract on Hewlett-Packard, and sell one on Dell Computer. If this sector as a whole goes up or down, the share prices will move together. If you buy one contract and sell the other, that neutralizes any sector effects, and you profit from the different relative movement of the shares. This idea is also called relative strength investing. You pick two competitors and decide which one will perform the best.

Narrow-based Indices

Another recent arrival is the narrow-based index. Rather than buying a contract on a broad index such as the S&P 500 or NASDAQ 100, you can now trade on narrow-based indices, such as energy, health care providers, telecommunications, etc. If you’re bullish or bearish on one of these sectors, the narrow-based index allows you to trade appropriately on the industry without having to select individual stocks. In effect, they act like a themed mutual fund.

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