Spread trading is a widely used trading strategy in futures markets that offers key advantages over outright futures trading (i.e., going long or short a single futures contract). These advantages include, capital efficiencies with lower margin outlay and potentially superior risk-adjusted returns, which is particularly true for the precious metals markets, where the underlying commodities demonstrate strong correlations with each other due to close economic links but also distinct fundamental drivers that can create profitable spreading opportunities using the associated futures contracts.
A spread trade using futures is created by buying a futures contract and simultaneously selling another futures contract against it. The futures spread trade acts as a hedging transaction, altering the trader’s exposure from an outright price fluctuation, to the price differential between the individual legs of the spread trade. The profitability of a futures spread trade will depend of the price direction, or differences, in price movement for the legs of the strategy. Spread trades may be executed across many markets but traders often look at similar contracts, or related markets, for spread trading opportunities. A closer relationship between the spread markets means the individual legs are more likely to move in tandem, enabling relatively stable price changes governed primarily by the pace of price moves between the legs (i.e., the relative performance of the legs), thereby reducing the level of risk for the trader. These strategies are referred to as relative value strategies.
Spreads may be broadly classified as intramarket spreads and intermarket spreads.
Intramarket spreads, also known as calendar spreads, are where a trader opens a long or short position in one contract month and then opens an opposite position in another contract month in the same futures market. Given the popularity of these spread trades as well as their contribution to futures rollover activity, dedicated calendar spread markets are available on the CME Direct platform, which allows spread execution with no legging risk.
Intermarket spreads, involve two separate, but related, futures markets with the legs having the same maturity time frames. Intermarket spread strategies may have legging risk, but it can be mitigated by using dedicated intermarket spread contracts, where available, or by selecting liquid underlying contracts for each leg in conjunction using auto-spreading functionality offered by some software vendor trading screens.
The main advantages of spread trading are reduced volatility and lower margin requirements as the legs are generally in related markets at the same exchange.
Compared to outright futures which can exhibit significant price swings, spreads can demonstrate extended trending price moves making it easier for traders to visualize patterns and thereby take a directional view or implement a technical trading strategy.
The precious metals complex includes gold, silver, platinum and palladium and offers trading opportunities to a global market through a wide variety of instruments available in the market such as the futures. These markets not only provide highly correlated commodities, but also with unique price drivers that can create many attractive spread trading opportunities.
While market participants can choose from the range of instruments available for trade execution once they have identified their preferred strategies, the precious metals futures markets at CME Group offers highly liquid and deep markets that enable the fast, efficient execution of spread strategies with the additional benefits of considerable margin savings (as all trades are centrally cleared through CME Clearing) and much alleviated legging risk. More importantly, these futures contracts are predominantly electronically traded (over 90%) on CME Globex allowing easy access for participants across the world and high-quality trade executions nearly 24 hours a day.
The Gold-Silver Ratio, or GSR, indicates the price of gold relative to silver and is calculated as the price of gold divided by the price of silver on a per-troy-ounce basis. It reflects how many ounces of silver a single ounce of gold is worth. Since 2013, the ratio has widened out from 55 to 75, reaching a high of 83.5 in March 2016. In the last two years, the GSR traded within the range 65.5 and 83.5.
Whilst both metals are considered precious and may trend together, gold is viewed as a global currency and is often used as an inflation hedge and safe-haven asset in times of market uncertainty. Silver has more industrial applications, with 50-60% consumed in industrial end-use compared with 10% of gold. Silver prices are sensitive to the economic cycle. The gold-silver ratio widens if gold prices experience a larger percentage gain relative to silver prices in times of economic or geopolitical uncertainty. Silver prices outperform gold in times of economic recovery as industrial demand picks up and puts the ratio under pressure. The ratio may be viewed an indicator of the health of the global macro economy.
Silver prices are generally more volatile compared to gold prices (at time of writing, 20d historical volatility for gold and silver were around 9% and 19% respectively). When gold prices fall, silver prices are likely fall more and vice-versa. Consequently, the Gold-Silver Ratio tends to be driven on numerous occasions principally by moves in the price of silver.
Trading the Gold-Silver Ratio, a technical trader would look to determine a preferred point to enter and exit the spread. Fundamental traders, would assess the supply-demand imbalances and the macro conditions for each metal to take a directional view on the ratio before initiating a trade. Irrespective of the trading approach or a mix of both, Gold and Silver futures contracts at COMEX offer cost-effective and highly liquid instruments for the GSR trade.
The following screenshot for the most active COMEX Gold and Silver futures contracts on CME Globex shows extremely tight and liquid markets for the metals. The top of the order book is generally about one tick wide and there is abundant depth in the book beyond the top level for both the contracts.
On March 1, a trader believes that gold prices will outperform silver prices in the short term. The trader decides to go long the Gold-Silver Ratio by buying one April Gold futures contract at $1,248.90/oz and simultaneously selling one May Silver futures contract at $18.445/oz, keeping the notional amounts for the legs nearly similar ($124,890 and $92,225 respectively). The trader has thus initiated the GSR trade at 67.71. The following tables show the trader’s realized profit and loss should the GSR move in their favor (i.e., firms up).
One of the benefits of spread trading with futures is the reduced cost of margin, otherwise known as margin offset. Margin discounts can occur when CME Clearing scans the trader’s portfolio of futures positions looking for offsets.
In our example, we had a long Gold position and a short Silver position. This spread position would have been identified as an offset and therefore would require less margin than the two outright positions.
For more information, visit the product specification pages on cmegroup.com/metals.