Futures Spreads and Signed Prices
Spreads instruments trade on CFE in a well-defined universe of two, three and four legged spreads with a restricted set of ratios and buy/sell conventions as shown in the table below. The notation S(1):B(1) means sell the first (earliest) expiration and buy the second (latest) expiration. The ratios of each leg is one, which means one unit of the spread contract is equivalent to selling 1 unit of the first expiration and buying one unit of the second expiration.
| Legs | Spreads (B=Buy, S=Sell, ()=Ratio) |
|---|---|
| 2 | S(1):B(1), B(1):B(1), S(1):B(2), S(2):B(1) |
| 3 | B(1):B(1):B(1), B(1):S(2):B(1) |
| 4 | B(1):B(1):B(1):B(1), B(1):S(1):B(1):S(1), B(1):S(1):S(1):B(1) |
The bold two leg spread - S(1):B(1) - is a special spread that always exists in the CFE system. As new contracts are listed, the S(1):B(1) two leg spread instruments are automatically created between the new contract and all existing active contracts.
Spread instruments can result in executions where the buyer gets paid and the seller pays. This can be non-intuitive in all but the simplest spreads. Consider the simplest two leg spread VX1:VX2 comprising selling one unit of the VX1 contract and buying one unit of the VX2 contract. To illustrate how buyers can get paid and sellers can pay, we examine spread pricing in Contango and Backwardated price environments.
Figure 1 below illustrates spread pricing in a Contango price environment in which the price of the early expiration contract is lower than the later expiration contract. In this example the Bid/Offer of the VX1 simple contract is 15.00 x 15.50 and the Bid/Offer for the VX2 contract is 16.50 x 16.75. The synthetic market for the VX1:VX2 spread (i.e., the Bid/Offer implied by the leg markets) is 1.00 x 1.75. The bid of 1.00 derives from the fact that the offer on the VX1 leg is 15.50 and the bid on the VX2 leg is 16.50 and the net of the two is 1.00 net debit (i.e., buyer pays). Figure 1 shows the implied spread market in italics. This is the normal intuitive situation where spread buyer pays and seller gets paid.
Next, consider the same example in the context of a Backward, or Inverted, market in which the price of the early expiration is higher than the price of the later expiration. Figure 2 below illustrates spread pricing in a Backward price environment. The Bid/Offer of the VX1 simple contract Is 16.50 x 17.00 and the Bid/Offer for the VX2 contract is 15.50 x 15.75. The synthetic market for the VX1:VX2 spread is -1.50 x -0.75. The bid of -1.50 derives from the fact that the offer on the VX1 leg is 17.00 and the bid on the VX2 leg is 15.50 and the net of the two is 1.50 net credit (i.e., buyer gets paid).
Spread pricing requires thinking of instrument prices on the entire real number line and not just positive numbers. In the example above the bid is less than the offer as it is left of the offer on the real number line. One can buy at the offer (paying -0.75 = receiving 0.75) and subsequently sell back at the bid (receiving -1.50 = paying 1.50), giving up the bid/offer spread (0.75) in the process; the same as positive prices. This concept generalizes to two and three leg spreads and unequal ratios; prices can just as easily be negative as positive as a result of the pricing environment (i.e., shape of the price curve vs. expiration date) and the spread definition (which legs bought/sold and ratios).