Spreading and Legging: What on Earth?

A common area of confusion for a new or even intermediate level futures trader is the idea of a spread, particularly how to transact in one. This write-up will look at the two ways in which to enter a spread.

What is a Spread?

In FX trading, the term spread refers only to the difference between the buy price and the sell price – the so called ‘bid/ask spread’.

That term also applies to futures, but we have the additional application when trading the difference between two products.

When you hear the term ‘spread trading’, this is referring to trading one market versus another, specifically trading the price differential between the two (or more) markets.

A non-trading example would be down at the fruit markets. Imagine for a moment that the prices fluctuate quite a bit over the course of one day. At a particular moment, you see red apples trading at 4 cents per kilo and green apples trading at $10 per kilo.

It doesn’t sound right does it? At those prices you’d buy as many reds as you can for 4 cents and sell as many greens for $10. In a fluctuating market, you’d expect that differential to come in at some stage.

In the futures markets, what about the spread between one delivery month and the next? Let’s use Crude Oil to illustrate. Keeping things simple, we’ll look at September and December deliveries.

Now there is bound to be a difference between these prices. Same commodity yes, but different delivery time will affect the prices at which each one trades.

We will not go into those factors here, but let’s say we had a situation where September delivery was trading at $95 and December was trading at $120. You don’t need a PhD to realise that’s a pretty wide spread. The trade to make would be to buy the Sep and sell short the Dec with a view of that spread narrowing from $25 to something closer.

In the real world, that spread is much tighter than $25 and is actively traded just as the individual contracts are traded. Interesting huh?

Transacting in a Spread

Spread trading is a big topic, as we will not cover all bases here. Here we will just look at how to transact.

There are two ways to enter a spread. The first one is legging. The term ‘leg’ applies to the individual contracts traded. In our Crude Oil example, the Sep contract is a leg and the Dec contract is a leg.

Legging is when we simply transact in each of the two to form a spread. In the $25 differential example above, if we were to buy Sep and sell Dec, we would be trading each leg of the spread separately. That is legging.

Some software packages allow you to create and trade what they call a ‘synthetic spread’. That is simply one leg minus the other – Sep minus Dec. At the software level, this allows you to:

  1. See the difference in prices.
  2. Transact at specific price differentials.

How else would you do it?

Rather than that spread being calculated at the software level (or in your head), a futures exchange will offer pricing for the spread. So called exchange traded spreads again allow you to see the price differential and transact at those prices.

The advantages of using an exchange trades spread are:

  •   You see the volume and depth of all others trading in that spread (transparency).
  • You do not have the risk of being filled in one leg and not the other (lower risk).
  • It is a one-click transaction (easy!).
  • Pricing is generally better than when legging the spread (more money to you).

A Crude Example

Back to our Sep-Dec spread. At the time of writing, it’s just after midnight Chicago time. Crude Oil is very thin this time of night. It is a good time to illustrate the difference between legging and using the exchange spread.

We use the depth or ‘ladder’ display to show all bids and offers. The basic layout is as follows:

depth1

With that in mind, let’s look at the ladders for the Sep and Dec contracts as well as the exchange spread:

depth2

There are a couple of things to note here:

  1. The exchange spread has a lot more volume (bids and offers) than the outright contracts. This might not matter if you are only trading a few contracts, but any more and it will matter.
  2. The difference between the bid and ask (the bid/ask spread) for the exchange spread is tighter that it would be when trading the two outright contracts (see below). That matters no matter what size you are trading.

Legging and Bid/Ask Spreads

Pricing is an important issue when comparing a legged spread to an exchange spread. In the above example, we’ve fed the numbers into Excel to calculate the bid/ask of the legged spread versus the exchange spread.

depth3

The thing to pick up here is the exchange spread price (bid:1.57, ask:1.59) is better than the legged or synthetic spread (bid:1.56, ask 1.60). That is pretty much always the case given heavy activity in the spread and thin activity in the more distant month (in this case December).

In this example both the bid and ask are only 1 cent (or $10 per contract) better. So what you say? That might not matter to most, but it’s not always that tight. A few seconds before I took this snapshot, the synthetic bid/ask was wider, making the exchange spread 3 cents or $30 better off.

In other markets, the difference can be even greater.

However even if it’s just $10 and always $10, why throw away money? It all adds up.

Bottom line is when transacting in spread, the best option in terms of pricing, volume and ease of use is almost always the exchange traded spread.