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By Brad Zigler

The inherent volatility of the energy markets can make them very dangerous places for retail investors to trade, especially in transitional periods. The roiling crude and distillate marketplace can bounce thinly capitalized traders out rather rudely and rather quickly. Spread trades can stretch an investor's capital and minimize risk.

We've examined spreads before, mostly to good effect. Often, though, newer readers ask why we bother talking up these trades. "Spreads are too complicated and expensive" is an oft-heard plaint.

Well, I'm here to tell you they ain't. Complicated or expensive, I mean.

A spread is a trade in which two or more futures (or options) are combined to exploit a change in their price relationship. Traders will buy or sell outright futures when they have definitive expectations about the direction and degree of a commodity's price movement. A long position, for example, will only return a profit if the underlying commodity moves above the contract's break-even price. Spreaders consider the contracts' absolute price levels as secondary to their relative values. A spread may, for instance, narrow whether the market environment is bullish or bearish.

Spreads are often used as training wheels for novice futures traders. There are a couple of reasons for this. First, spreads are often less volatile and more predictable than outright trades. Spreads are often seasonal in nature and tend to recur reliably. All this makes spreads seem less scary for the neophyte.

Second, a spread's capital commitment may be significantly smaller than that required for an outright trade. This gives spreaders more bang for their margin bucks. Let's look at an example to see how it works.

Suppose, in November, when spot was $1.0125 per gallon, you wanted to trade gasoline on the long side (gasoline, like heating oil, trades in contract lots of 42,000 gallons). With an initial margin requirement of $9,450 and a maintenance level of $7,500, there's room for as much as a 6.25 cent-per-gallon decline, or a fall to 95 cents, before a call for variation margin would be issued.

Even though gasoline eventually topped $1.16 within two months, interim volatility would have dragged your account's equity below the maintenance level three times en route. Supporting the position would have required a total cash commitment of more than $20,000. For that, you would have earned a net investment return of 31%.

Let's see what would happen if you instead decided to spread your long gasoline position against, say, a short sale of heating oil.

As we've seen, the initial requirement for a gasoline contract is $9,450. The performance bond for a heating oil contract is $10,125. You don't put up the full requirement for each contract when you trade a spread, however. The exchange clearinghouse grants a 65% margin credit on each leg of this spread, so your total bond would be only $6,852.

Your spread will be margined as a unit, rather than as two separate contracts. Even though an outright contract may be subject to a maintenance call at a certain price level, as your outright gasoline positions was, there may be no call if that contract's part of the spread. Gains and losses on the spread's component legs are netted for margin purposes.

With gasoline at $1.1025 and heating oil at $1.6710, our spread starts out $0.6585 in favor of oil. If you felt that oil's price advantage is due to shrink, you'd spread a long gasoline contract against short heating oil. The maintenance level would be $5,075, reached if the spread widened to $0.7008 (remember, you want the spread to narrow).

Here's how the trade pencils out:

Date

(Long)

Gasoline

(Short)

Heating Oil

(Long)

Spread

20-Nov-08

$1.0125

$1.6710

-$0.6585

21-Jan-09

$1.1650

$1.4035

-$0.2385

Net

+$0.1525

+$0.2675

+$0.4200

Not all spreads end up with gains on each leg like this one. No matter, though. If a gain in one leg exceeds the loss in the other, a profit will be realized. A large loss in one leg can, conversely, swamp a complementary gain. The bottom line is, literally, in the lower right-hand box; the gains and losses of the spread's legs are netted there.

Here, the spread's 42-cent gain translates to a $17,640 profit ($0.42 x 42,000 gallons), yielding a 257% return on margin. With the spread, a higher return was realized, compared to the outright gasoline trade, and there weren't equity variations large enough to trigger maintenance calls.

Obtaining more leverage with less apparent risk may sound too good to be true, but spreaders have been relying upon these kinds of trades for generations. Spreads don't guarantee you against loss, of course. They simply allow you to exploit market nuances in a manner not possible with outright positions.

Source: Energy Spreads Offer Leveraged Profits, Reduced Risk