Spread Trading Alchemy
Aikin, Stephen, Modern Trader
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. …