Spread Trading Alchemy

By Aikin, Stephen | Futures (Cedar Falls, IA), July 2007 | Go to article overview

Spread Trading Alchemy


Aikin, Stephen, Futures (Cedar Falls, IA)


Most experienced traders are familiar with financial futures and their intra- and inter-contract spread markets, but not so many understand how spreads allow risk profiles to be changed to order.

Exchange-traded financial futures are well-used, highly liquid instruments, offering regulation, standardization, transparency and removal of counter-party risk. They are usually the first point of liquidity for a hedge fund or institution that is looking to establish or remove an outright interest rate or equity position.

However, it is the spread market that offers the trader another dimension - a relative value marketplace, where it is the relationship between two or more instruments that counts, not the outright direction. Of course, most of these spread markets are familiar to financial futures traders, but the relationships also allow positions with flexible risk profiles that can be adjusted to fit different needs.

Financial futures spreads have two broad categories: intra-contract and inter-contract, both being based on the two popular asset classes of interest rates and equities. Interest rate futures offer the widest range of trading permutations and have the substantial benefit of a mathematical dependency, something that is often forgotten by equity traders, but equity index futures and stock futures also can offer exciting combinations.

Intra-contract spreads are probably the most closely watched and traded. They are also the simplest to understand and follow. Perhaps the most common intra-contract spreads are the bond futures or index futures calendar spread. This is a short lived but highly active trade based around the roll over from an expiring contract into the new front month.

Such spreads are a melting pot of open-interest dynamics and short-term interest rate or repo rate influences. However, a larger, longer-lived intra-contract spread market exists in the Short-Term Interest Rate (Stir) futures markets. These are futures on short-term interest rates and are the largest markets in the world by nominal value. It is by no means unusual for the two largest contracts, the Eurodollar and Euribor, to trade in excess of one trillion dollars (or euros) each day. Also, most financial futures only have one active delivery contract (the front month), but Stir futures can have up to 40, as in the case of the Eurodollar. This means there are an enormous number of spread permutations within the futures complex, which can be traded independently as calendar spreads, or relatively as a butterfly or condor spreads.

The inherent risk in these spreads is curve risk and it follows that the longer the period between the component contracts, the more price movement there will be. A one-year calendar spread such as the Eurodollar June 2007 (M7) and the June 2008 (M8), knows as M7M8, will be more volatile than the three-month June 2007, September 2007 spread (M7U7).

However, despite their different risk profiles, these two spreads are intrinsically linked because the M7U7 spread covers a quarter of the period of the longer M7M8 spread. This relationship can be used to adapt or modify the risk profile of a spread by trading it against another. For example, a position in the one-year M7M8 calendar can be rolled into a three-month M7U7 spread by trading it against a nine-month U7M8 spread or any of its combinations, such as the six-month Z7M8 plus the three-month U7Z7.

Trades like those are popular among intra-contract spreaders who are trying to establish a position in the highly liquid three-month calendar spreads by means other than joining a highly competitive order book. These spreads are always hugely popular because they are simple to follow, transparent and contain only curve risk. Also, because they are instruments within the same complex, there is no basis risk (Eurodollars have a static dollar-point value of $25) and no credit risk.

In contrast, inter-contract spreads (spreads between Stir futures and bond and swap futures) are a fusion of all these kinds of risks, plus some more esoteric ones such as convexity risk, which is dependent on the volatility of short-term rates, but rarely a major influence for a duration of two years or less. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Spread Trading Alchemy
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.