What are spreads?
You may have heard the term ‘bid-ask spread’ in the trading context some time or the other. If you haven’t, it simply means the difference between the bid (buying) price and the ask (selling) price of an asset. Trading spreads, however, relates to the trading of futures contracts.
For the entirety of this post, a spread is defined as the simultaneous sale of one or more futures contracts while buying an equivalent number of offsetting futures contracts. This, in effect, means that you are simultaneously long (buying futures) and short (selling futures). Quoting Joe Ross, inventor of the Ross Hook, “A spread tracks the difference between the price of whatever it is you are long and whatever it is you are short. Therefore the risk changes from that of price fluctuation to that of the difference between the two sides of the spread.”
The opposing positions or contracts are also referred to as the legs of the spread.
The futures contracts you trade as the part of trading a spread, can be related or in completed different markets. This brings us to two types of spreads:
Intra-market Spreads: This involves going long and short in the same market but in different months. For instance, if you are trading in the BTC futures market, you can decide that you’ll go short on BTC Mar’19 contract but long on BTC Jun’19 contract. This will constitute an intra-market spread, in this case being traded as a calendar spread. We will touch upon calendar spreads in a later section.
Inter-market Spreads: If you go long in one futures market but short in another, then that is termed as an inter-market spread. As an example, you can go long on BTC perpetual swaps while shorting ETH perpetual swaps or go long on BTC Jun’19 contract while going short on ETH Jun’19 contract.
Why trade spreads?
Spread trading allows capitalizing on market opportunities not provided while trading futures outright. Check out the spreads between BitMex perpetual futures (XBTUSD), March BTC futures (XBTH19) and June BTC futures (XBTM19) on different dates.
On Jan 3, 2019
On January 3rd, 2019 the spread between perpetual futures and March futures was ~$110 while that between perpetual and June futures was ~$170.
On Jan 6, 2019
On January 6th, it became ~$95 between perpetual futures and March futures and ~$125 between perpetual and June futures.
On Jan 14, 2019
On January 14th, it was ~$92 between perpetual futures and March futures and ~$123.5 between perpetual and June futures.
Suppose you sold the perpetual-June futures spread on Jan 3rd at $170, then bought back on the 14th at $123.5, your profit would’ve been $46.5! Let’s examine some details of doing such a trade. To effectively sell the spread on Jan 3rd, you’d need to sell XBTUSD and buy XBTM19. On the 14th, to effectively buy back the same spread, you’d need to buy XBTUSD and sell XBTM19. Now let us compare this with trading the two futures contracts as outrights. If you shorted both XBTUSD and XBTM19, your profits would have been $296 and $250 respectively. Looks more lucrative than the spread, right? However, if you went long, your losses would be $296 and $250 for the respective contracts. In contrast, if you went long on the spread, your loss would have only been $46.5 for the trade. Thus, spread traders are exposed to lower risk.
Experienced traders will note that the role of margins has been excluded in the example presented. Even with margins, the central idea of lowered risk stays true. Furthermore, in traditional markets, spreads are traded at lower margins as compared to futures outrights. We’ll touch upon this in the next section in more detail.
In the context of exchange-traded spreads (currently only available in traditional markets), these are all the advantages spread trading:
Lower risk: As the price of a spread is the price difference between two offsetting positions, it is always less volatile than the price of the underlying outright futures contracts. Thus, as shown in the aforementioned example, the risk is lower when trading spreads.
Lower margins: Trading on leverage allows traders to take bigger positions via margins when compared to trading without leverage. Margin requirements are usually 1/x*position taken where x is equal to the trader’s leverage. However, as risks are lower in spread trading, margin requirements are lower comparatively. Do note this hold valid only for exchange-traded spreads; taking a spread position via individual contracts will result in margins adding up. (See next section.)
More opportunities: The BitMex futures contracts example was a mere glimpse into the potential of spreads. With futures outrights for numerous coins becoming available, numerous opportunities to trade spreads will spring up for traders.
IDAP instruments: Calendar Spreads and Butterfly
The example of the previous section deliberately skipped the role of margins in the entire trade. Do note, that in order to take that spread position on BitMex, all the individual contracts will have to be bought/sold manually by a trader. With that, we run into a couple of problems:
Margins will pile up: Spread trading is advantageous since margins required are low. However, since on BitMex, the effective trading of the spread will require market buy and sell of all the futures contracts involved, a trader will have to pay margins for all the individual trades. Consider a simple example of taking a spread position by going long on March BTC futures (XBTH19) and short on June BTC futures (XBTM19). Now if you pay X as margin on one contract (or one leg), then overall a trader will end up paying 2X!
Losses from slippage: Again, since a trader won’t actually be trading an exchange-traded spread, trying to simultaneously buy and sell two offsetting futures to take the spread position will be impossible. The time difference between selling one contract and then buying the other will end up in costing the trader if the market moves significantly while he is executing the two orders in sequence.
Spread position unwittingly converting to a naked position: A position taken in the outrights futures market is also popularly called a naked position, as your risk is not hedged (or is in effect naked) as opposed to in the spreads futures market.
In the BitMex example, as there is no actual spreads market, there is a chance that one of the legs of your spread liquidates automatically due to the market movement, while the other does not. Unless you manually sell the other contract too, spread position will simply become an outrights position, defeating the whole purpose of the trade.
The problems mentioned above do not occur if spreads are traded on exchanges as derivatives instruments. Thus, to provide low-risk traders with the opportunity to trade spreads easily, IDAP is introducing to the crypto space two exchange-traded spreads: Calendar Spreads and Butterfly!
The price difference between IDAP’s monthly futures contracts will be traded as Calendar Spreads while the difference between two Calendar Spreads will be traded as Butterfly. With a Butterfly spread, a trader will be able to bet on the entire market curve in a given time frame, effectively combining both a bull spreads strategy and a bear spreads strategy to create a neutral spreads strategy. The risk will be even lower than that for Calendar Spreads!
As for margins, we will charge only for one leg of the spread, which, again due to our nominal fee will be quite low. A butterfly spread position, which involves three contracts, will also be charged for a single leg! Going forward as the market matures, we will re-evaluate the margin requirements for spreads and lower them even further!
Trading spreads easily with IDAP Matrix
Not only will IDAP offer traders the above-mentioned derivatives instruments to trade spreads effectively but also provide the necessary tools to enable easy visualization and trading!
With the IDAP Matrix, specially designed to assist derivatives traders, traders will be able to view market data for all contract expirations of an asset as well as market data for exchange-quoted spreads for the underlying asset, all in one window. Traders will have the ease to trade, place, modify and cancel orders directly through the IDAP Matrix.
Furthermore, the IDAP Spreader will serve as another crucial tool for spread traders. The IDAP Spreader will allow traders to create, manage and execute synthetic spreads based on futures contract available on the IDAP exchange. Synthetic spreads are inter-market spreads, whose prices are not quoted on the exchange itself but have to be calculated based on the underlying contracts listed on the exchange. For example, a user can create synthetic spreads of Bitcoin (BTC) and Ethereum (ETH) through the exchange quoted spreads of BTC and ETH.
IDAP is pioneering in bringing instruments to the crypto trading markets which expand the choices for traders and let them trade more strategically within their risk-appetites. Our TestNet is now live and accessible to all! Please try it out by registering for a TestNet account by visiting testnet.idap.io. Both the Web Interface and the Desktop Trading Platform (IDAP Trader) are up and running. Your feedback on the TestNet is most valuable and much appreciated!
Phase-I of the IDAP public sale goes live on Feb 15th, 2019. You can check out complete details for phase-I in our official announcement on Medium.