Why Trade Spreads?

By Brad Zigler

More and more, people ask me why I write about spread trades. A typical gripe is: "Why bother with two positions? It's simpler to just buy or sell something outright." That it is. But outright buying or selling of futures means you're also taking on big risk. Being short gold yesterday, for instance, would have hurt you B-I-G time. Being short gold and simultaneously long silver, however, would have been a money maker. (How much of a money maker? A 16% return on margin for just one day.)

In whipsawing markets, spreads may be some of the safest (relatively speaking) places to be. Think of it this way: you're short something, you're long something else. It doesn't really matter if one or the other goes up or down as long as the price relationship moves favorably for you.

And price relationships can often be more reliably predicted than the movements of individual commodities.

Case in point: oil versus natural gas. We laid out the case for a seasonal shrinkage in the energy premium commanded by crude oil just before the Labor Day holiday ("Spreading Oil and Natural Gas") which, if traded as a 1-to-1 spread - that is, short crude oil and long natural gas - would have cranked out a 125% return on margin in just a dozen trading days.

Crude Oil/Natural Gas Spread

Not every spread, of course, can produce gains with such rapidity. Neither is a profit assured. Spreads sometimes lose. But the reliability of this spread over the past 15 years makes it particularly compelling.

And what if you can't trade futures? The spread's entry and exit points can also be used to time a long position in the United States Natural Gas Fund (AMEX: UNG), an exchange-traded portfolio that tracks natural gas futures. Since September 3, UNG has gained 8%.