Trading strategies: Speculation, hedging and spread trading in futures markets

Introduction

Investors can participate in the futures market in several different ways, that is, long or short a specific contract. With this flexibility, futures can become strategic assets in investors \'portfolios.

Investors can strategically use futures to achieve multiple goals. Three common strategic methods in futures markets include speculation, hedging, and spread trading.

Speculative price changes

Speculation involves predicting future price changes and taking corresponding positions accordingly. When investors speculate in futures, their goal is to make a profit by going long or short based on market expectations.

If speculators think the price of an asset will rise, they may go long by buying futures contracts, intending to sell at a higher price. Conversely, if they think prices will fall, they may take short positions, sell futures contracts, and plan to buy back at a lower price.

In both cases, the goal is to correctly predict the market\'s direction and gain potential profits from price fluctuations.

Manage risk through hedging

But making profits is not the only reason investors trade futures. Investors can also use futures to hedge, which means protecting their investments by reducing risk.

Let\'s take an example from an investor who owns Ethereum (ETH). If they believe in its long-term value but are concerned about short-term price declines, they can choose to hedge. To do this, they can short nano ether futures, sell contracts at current prices, and expect to buy them back at a lower price when the value of ether (ETH) falls.

Investors hold 1 Ether (ETH) at a price of US$4,000. They hedge their investments by shorting 20-nanometer ether futures. Each nano ether futures represents 1/10 of Ethereum (ETH). Therefore, the nominal value of the contract is 20×400= US$8,000.

These contracts require an initial margin of 30%, which means that to open a position, investors need to deposit US$2,400 (30% of US$8,000) to control 20 contracts.

Then the price of Ethereum (ETH) fell to US$2,000, so the value of each nano Ethereum futures contract fell to US$200. In other words, the value of 20 contracts is now 20×200=$4,000. In order to close the position, investors buy it back at that price.

Since the initial value of the contract was US$8,000 when investors sold it, it is now US$4,000, investors gained US$4,000 from short positions.

This profit can offset the loss in the value of Ethereum (ETH) actually held by investors. By using nano-ether futures to hedge, investors can reduce the impact of price declines on their overall investment portfolios, thereby managing risk more effectively.

Leverage spread trade arbitrage

Arbitrage is a futures trading strategy in which investors aim to profit from the price difference between two related positions, rather than guessing whether the market will rise or fall. In other words, the focus is not on the overall direction of the market, but on the trend relationship between the two contracts. There are many different types of spreads that can be used to achieve this goal.

Cross-market spreads

Inter-market spreads involve two different but related asset positions. The goal is to profit from the price difference between two assets, rather than just betting on the direction of one asset.

For example, if investors think the price of bitcoin futures will rise, they may go long bitcoin futures. In order to spread and reduce risk, they can also hold short positions in gold futures, expecting gold prices to fall.

If the price of Bitcoin rises and the price of gold falls, investors will profit. With the spread, even if gold prices rise or remain stable, investors can still profit from the first spread or minimize losses.

Calendar spread

Calendar spread is also called \"intra-market spread\" and is a more advanced trading strategy. In the calendar spread, investors simultaneously open a short position and a long position on the same asset, but with different expiration dates. The purpose is to profit from the price difference between the two contracts over a period of time.

For example, if investors want to enforce calendar spreads, they can short the March 2025 Bitcoin futures contract and long the April 2025 Bitcoin futures contract.

Prices will not remain completely stable due to market fluctuations. However, if prices are relatively stable, investors can make a profit even if a loss occurs on one of the spreads.

Arbitrage strategies such as calendar spreads or inter-market spreads can limit the impact of overall market trends and focus instead on relative price movements. By holding positions in different contracts or assets, investors can hedge one contract against another, potentially reducing the risk of sudden market fluctuations. Their goal is not to focus on the overall direction of the market, but to profit from the price difference between the maturity dates of the underlying assets or contracts.

Review

Key Terms

Hedging

Protect investments by creating long or short positions in hedging futures to reduce risk.

Arbitrage

Calendar or intra-market spread: Opening positions on two futures contracts with different maturity dates on the same asset at the same time, with the purpose of profiting from the price difference between the two contract expiration dates.

Inter-market spread: Holding positions in two different but related assets with the intention of profiting from the price difference between the two assets rather than betting on the direction of only one of them.

In the futures market, investors can adopt a series of strategies based on their goals. Each method can be used to increase profits or manage risk.

Futures are rarely used alone, but instead function as part of a broader investment strategy that has the potential to increase and protect the health of investors \'overall portfolio.