Friday, September 26, 2008

Equity Index Futures Spread Trading

Spread trading has been around for ages. However the equity index spread is becoming popular only recently. Though many hedge funds use this in their strategies, it has not been a product of interest to speculators. It is a well-known fact that the equity markets of the world are correlated to a certain degree. You may see Nikkei225 drop 5% in the morning and you immediately sense it’s a bad day for the Indian market as well. You may see the DAX futures drop by 3% and you sense it is a bad day for the American markets as well.

Spread trading is beneficial in cases where you fail to have a directional sense on the market. You can have a spread between two equity index futures, which care correlated to a greater extent. If you are interested in Indian markets, you can create a spread between sensex and nifty futures. That means you need to initiate a short position in one contract and long position in another. However the number of lots in both contracts could be different. Since I am more familiar with the US equity markets, I will use the index futures of US in my examples from now on. The S&P500 and Dow futures are correlated to a large extent. This is because of the fact that all the Dow 30 stocks are also in S&P500 and also they constitute a major part of S&P500 index. You can use 5 contracts of S&P500 and 6 contracts of Dow in your trading to achieve dollar neutrality. The Spread trading of S&P500 and Dow is explained clearly on the CME (Chicago Mercantile Exchange) website.

The other use of spread trading is to trade during the announcement of important figures. There might be news, which affects the American markets more than the European markets. Depending on this you can create a spread between an American equity index futures contact and a European equity index futures contract. This has not yielded profits all the time. Spread trading can sometimes give more loss than outrights. There is a possibility that you may suffer from loss on both legs. This usually happens when you hold your positions for a long time.

Trade responsibly. Futures trading might not be suitable for every one.


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