Price Convergence with Cash and Futures
Futures contracts have a set expiration date, on which the price of the futures contract is meant to converge with the underlying asset or cash position's price. This convergence of the cash price and the futures price is known as the narrowing of the basis.
For those entities that use futures contracts to hedge their cash position this narrowing of the basis is essential. If a farmer grows soybeans he hopes that the cash price will continue upward while the short futures contract is simply a hedge, a protective position designed to lose money. A soybean processor that wants to protect himself from prices moving upward will buy a futures soybean contract, while still hoping that prices will drop. If the price moves up they will gain it back in the futures market; if the price gets weaker they are ready to lose money in the long futures position so that they can make cheaper purchases in the cash market. Both types of hedgers really have nothing to lose as the futures price gets closer to the cash value.
For retail traders this experience can be duplicated by playing the convergence of the spot currency market with the futures currency markets. For example, by following the 50 day MA you can determine the currency market's trend or counter-trend . Once the trend is determined the spot market can operate as the primary position and the futures can operate as the hedge, with the goal of holding on to the position until they reach the same price.
There is a drawback to playing a convergence spread, though. In 2008 the Commodity Futures Trading Commission's Agricultural Committee had an emergency meeting regarding the convergence of grain futures and their cash counterparts. Apparently, for several years the affects of carrying charges and speculation were so severe that even at expiration the futures grain prices were not matching up with the cash prices. This blatant discrepancy effectively ruined the cash grain market's ability to instill confidence in the commodity exchange mechanism of price discovery.
This problem, while currently concentrated in the grain markets, may portend the future of all commodities exchanges around the world. A significant number of money managers have been putting investors into futures contracts because of global inflation in the value of raw materials. This is a new phenomenon. Add to this new phenomenon the fact that a number of new exchanges are starting up mirror commodity contracts in order to siphon off liquidity from major exchanges around the world and you have a recipe for price discovery disaster occurring.
The number of hedgers out there is finite. All of the exchanges compete with each other for a limited number of hedgers looking to protect themselves, while speculators flood contracts with cash as they look for new opportunities to profit from worldwide demands. There is little doubt that the convergence spread between futures and the cash market days are numbered.
Conclusion
Spread trading is not perfect. On one hand, you have the opportunity to profit. On the other, you could end up with one successful side that doesn't really cover the losing side, or with two losing sides. Spread trades are also difficult to unwind. While your margin is inexpensive when the spread trade is on, if you try to unwind the spread you are immediately hit with new margin requirements. Finally, many of the traditional seasonal spreads are simply too well known to be as effective as they may have been years ago. Still, with all of these imperfections spread trading makes for a more than decent risk management strategy.
When done right spread trading allows a trader to take advantage of arbitrage opportunities. Those are the small discrepancies in price that speculators thrive on financially. Spread trading can reduce the most expensive markets to reasonable margins. Plus, spread trading transcends exchanges or trading vehicles. The spot price can be spread with the futures price. Different futures months can be spread against each other and options can be spread in any number of ways. Spread trading is simply one of the most versatile ways to trade for a trader of any skill level. The majority of the problems with spread trades can be resolved quite easily. As long as a spread trade is either backed up by another risk management strategy or there are stop limits in place to protect a spread trade from going terribly wrong there is no reason to fear this exciting risk management technique.
