How Metal Spreads Make More Money

Includes: DBS, IAU
by: Hard Assets Investor

By Brad Zigler

Years ago, when I was a young pup on the trading floor, a battle-scarred old-school trader told me, "Spreads are for ...." Well, I can't tell you exactly what he said. Let's just say he thought spread trading was wimpish.

We've often illustrated spread trades as a way to achieve nuance in the binary world of trading. Buying or selling futures outright casts you as either a bull or bear, concerned only about a rise or fall in the absolute price of a commodity. Trading spreads means you care more about the relationship between the position's contracts. (Gee, put that way, it's surprising "Dear Abby" doesn't opine on spreads.)

Take gold and silver as an example. You could have bought December gold or silver futures at the beginning of February and watched the metals' prices rise 10 percent and 42 percent, respectively. With present margin rates — $6,751 for a 100-oz. gold contract and $11,745 for 5,000-oz. silver futures — those rises would have translated into returns on margin of 195 percent and 516 percent. There's certainly nothing wimpish about those gains.

However, a spread playing the gold/silver ratio would have produced a bigger wad.

A spread, in its simplest form, entails the simultaneous purchase and sale of different, but related futures. If you, for example, thought silver was likely to outperform gold, you could buy silver contracts while shorting gold futures. You'd then be exposed to the ratio rather than the outright prices of the metals.

The exchange clearinghouse will give you a margin discount on the spread, provided you open the trade in the recognized ratio, now at 3:2. In other words, you'd have to buy three silver futures for every two gold contracts sold. The ratio spread qualifies you for a 50 percent margin credit.

The discount brings your initial margin requirement to $24,369:

  • Three silver contracts: $11,745 x 3 = $35,535
  • Two gold contracts: $6,751 x 2 = $13,502
  • Total: $48,737 less 50 percent discount = $24,369

On Feb. 1, the gold/silver ratio — basis December futures — was at 47:1. Now it's at 36:1. The futures spread's gained $155,420 as a result:

  • Long three silver contracts: $12.12/oz. gain x 15,000 oz. = $181,800 gain
  • Short two gold contracts: $131.90/oz. loss x 200 oz. = $26,380 loss
  • Net: $155,420

With a $24,369 performance bond posted, that makes a 638 percent return, more than you could have made with an outright futures position in either metal. The average daily return for the spread has been 1.5 percent, twice that of an outright silver trade.

Now, if spread trading makes me ... um, a wimp, then so be it. I'm wimpish and proud of it.