If you have to ask, “What’s a spread?” I offer an explanation below, a “spread primer” reproduced from my third book on commodity trading, Trading Commodities & Financial Futures.
On the other hand, if you know what a spread is feel free to skip ahead to my Trade of the Month.
Here’s the primer:
Spreads are a more sophisticated way of trading that fits well into the game plan of many traders. I know some traders who only trade spreads because they feel this is the best way to limit some of the risks inherent in futures and options. Actually, this is one of the main purposes of spreading–to reduce risk.
When you enter a spread, the objective isn’t to necessarily make money on a rise or fall in the market in question; rather, it’s to profit on a change in the relationship between different prices.
When you put on a spread you buy one contract while simultaneously selling another. You’re long and short in either two related commodities, or two different months of the same commodity at the same time. The relative change between the two determines your profit or loss.
There are two major categories of spreads, intramarket and intermarket.
Intramarket Spread. Intramarket spreads consist of buying one month in a particular commodity and simultaneously selling a different month in the same commodity.
Examples include buying July corn and selling December corn, buying March crude oil and selling April crude oil, buying May cotton and selling December cotton. Since you’re trading two different months in the same commodity, one long and the other short, their prices will tend move in the same direction.
So, how can one possibly make money in a spread? Well, while they may tend to move in the same direction, first of all they don’t have to, and even when the two months move in the same direction they generally tend to move at different speeds. While many times when you gain on one side of a spread, you lose on the other, what you’re looking for is a bigger gain on the winning side than loss on the losing side.
Let’s look at an example. Assume you put on a spread between March copper and July copper in December of the previous year. You’re buying the March and selling the July.
When you buy the near month and sell the distant, it’s called a “bull spread.” A “bear spread” (short March and long July) is the mirror image.
In a bull spread, you’re predicting the near-month will either rise faster than the distant or fall slower. Either outcome will be profitable.
Spreads can be more reliable and more predictable than outright positions, precisely the reason why many traders like them. There are never any “sure things,” but they can tend at times to put the odds in your favor.
Look at this particular example. The March copper most years tends to gain on the July due to seasonal considerations. March is historically a high-demand time of the year for copper due to inventory rebuilding prior to the peak building season.
Suppose March is trading at 102 and July is trading at 101 when you “place” the spread in December. You’ve put on this bull spread, long the March and short the July, with the March trading at a 100 points (1 cent per pound) premium to the July. (If the March was trading at 100 and the July at 102, you’d say you were long the March and short the July “with the March 200 points discount to the July.”)
A few months pass, and in February copper has risen in price with both months appreciating–but at different speeds. The March is trading at 115 and the July at 110. The spread has now widened from 100 points premium the March to 500 points premium the March, and you sense it is time to take your profits. You would give your broker an order to do the reverse transaction, that is sell the March and buy the July. This will offset both sides of the spread and effectively wipe your slate clean.
Let’s look at the result. The March has risen from 102 to 115, so you have a 13 cent, or 1,300 point, profit on this side of the spread. The July, the short side, has risen from 101 to 110, so you have a 9 cent, or 900 point, loss on this side of the spread.
The difference between what you gained and what you lost, 1,300 minus 900, is your profit–in this case 400 points.
Note you don’t need to calculate both sides to determine your profit. This works out neatly to be the spread differences; 500 minus 100 equals 400. Since one point in COMEX copper is worth $2.50 per contract, this is a gross profit (in other words, we’re not taking commissions into consideration here) of $1,000 per spread.
The question arises, “Why trade the spread when you could have made more money by simply buying the March outright?”
In this case, March rallied from 102 to 115, a 1,300 point move, or $3,250 profit versus $1,000. It all has to do with the risks versus the reward. Spreads generally move slower. Yes, you can certainly lose in a spread as well, but at times you can gain even if the market didn’t move the way you planned.
What if the economy weakened, and March copper fell 1,300 points? If you were long you would have lost $3,250 per contract. The spread could certainly fall 400 points, but it’s also possible traders would turn bearish the whole market and both months could go down the same amount, thus resulting in no loss.
When spread-trading, you’re more interested in the difference between the months than the outright “flat price” movements.
The ability to profit in both an up or down situation is one of the advantages of spread trading. Also, the margin requirements for spreads are generally much smaller than outright positions because the Exchange recognizes in most cases spreads are less risky.
If you’re long May corn and short September corn, and the president declares a grain embargo, odds are both months will be down sharply. In other words, you’re somewhat insulated from dramatic news with the resulting price shocks when spread trading.
Additionally, spreads tend to move slower giving you more time to react, and many traders believe they’re more predictable.
Intermarket Spread. Intermarket spreads consist of buying one commodity and simultaneously selling a related commodity.
Examples include buying silver and selling gold and buying Minneapolis wheat and selling Chicago wheat.
In these examples, the two markets are related, and they generally move in the same direction because the same market forces affect both. However, they will move at different speeds.
For example, you may decide to buy July corn and sell July wheat. Both are grains, they can both be used for animal feed, and both are export commodities. They’ll tend to move in the same direction; however, if the fundamentals are strongly opposed, they could move in opposite directions.
It’s March, and you believe the supplies of corn are tight, but wheat supplies will grow bigger as the market moves closer to the harvest in the early summer. July corn is at $3.10 and July wheat is at $4.50, so you buy the corn and sell the wheat with corn at a 140 discount to the wheat. (You always should read the order with the long, or the buy side, first.)
Intermarket spreads can’t be classified as “bull” or “bear” like an intramarket spread. Suppose a few months go by and both corn and wheat fall in price, corn to $2.80, wheat, due to harvest selling pressure, to $3.60. You decide it’s time to unwind the spread. You buy the July wheat and sell the July corn, which offsets both sides of the spread and wipes your slate clean.
The long side, the corn side, shows a loss of 30 cents, the short side a profit of 90 cents. Your gross profit is the difference of 60 cents, and since in grains a penny move is worth $50 per contract traded, this is a profit of $3,000.
Note you put the spread on at a 140 discount and took it off at an 80 discount; the difference between 140 and 80 is 60. In this case you wanted the spread to narrow; you wanted the lower-priced corn to gain on the higher-priced wheat, and it did. If the corn fell by 40 cents and the wheat by 20 cents, you would have lost 20 cents on the spread.
If there were some weather problems with the new-crop wheat, and the spread widened to 190 (wheat went up 40 cents and corn fell 10), you would have lost 50 cents, or $2,500 per spread.
Special Spreads. There are certain spreads that are actively and commonly traded. In certain markets there are spread brokers who only will make a market both ways in these common spreads. The exchanges will generally give the trader a break on the margin rates for trading the common spreads.
For example, while it may cost $700 to margin a wheat contract, because Kansas City and Minneapolis recognize intermarket spreads between their respective wheat markets, a long Minneapolis wheat-short Kansas wheat spread might only require $500 total (or $250 a “side,” not $1,400).
Grains. The new crop/old crop spreads are popular among traders who try to determine how the relationship will change between one crop that’s already been harvested and another that’s either in the ground or yet to be planted.
Common examples include:
· Long May or July corn/Short December corn
· Long May or July soybeans/Short November soybeans
· Long May or July soybean meal, or oil/Short December soybean meal or oil
· Long May or July oats/Short December oats
· Long March or May wheat/Short July or December wheat
Popular intermarket grain spreads include:
· Long or Short wheat versus corn
· Long or Short corn versus oats
· Long or Short soybeans versus corn or wheat
The soybean crush is used by the soybean processors to lock in profit margins when available. This involves the purchase of soybeans (the raw material) and the simultaneous sale of the products, soybean meal and soybean oil. The “reverse crush” involves the purchase of the products and sale of beans.
Cotton. The old crop/new crop July cotton versus December is popular and can be volatile.
Meats. The hogs versus cattle, cattle versus feeder cattle, and hogs versus pork belly spreads are the most popular. Some traders like to trade the “cattle crush,” which involves a purchase of corn and feeder cattle (the two “raw ingredients”) versus the sale of live cattle (the “finished product”).
Energy. By far the most popular energy spread is the purchase or sale of heating oil versus the unleaded gasoline as traders try to take advantage of the seasonal tendencies of these two products to move towards or away from each other. The “crack spread” is the simultaneous purchase and sale of the crude oil contract versus the products, gasoline and heating oil.
Metals. The gold/silver ratio spread is calculated by dividing the price of gold by the price of silver. It represents the number of ounces of silver required to equal the price of one ounce of gold.
In 1980, when gold was $850 and silver $50, the ratio was 17. However, in 1996, with gold at $350 and silver at $5, it was 70. I’m not sure there’s an average or a “correct number” here, but recently the ratio has traded between 30 and 70, with the average for the past century at 32.5.
The purchase of platinum versus the sale of gold is another popular metal spread, with a margin break for buying one and selling the other.
Interest Rates. A popular interest rate spreads is the NOB, or Treasury Notes versus Treasury Bonds, or the spread between the US Treasuries and the Bund or Japanese government bonds, or the Eurodollar versus Note spread (the relationship between short-term and longer-term rates).
Other limited-risk spreads include carrying charge spreads. Carrying charges are the cost to hold a commodity from one month to the next, and would include storage costs and interest.
For example, if it costs 3 cents a month to hold wheat and the July/September wheat spread is trading at 8 cents premium the September, by definition the risk on this one is low. Unless interest rates would rise dramatically, the likelihood September would rise much more above the July is minimal.
However, should a bull market develop in wheat due to tight nearby supplies, there’s no limit to how far July could rise above September. These are spreads to watch for.
Limited-risk carrying-charge spreads can only be found in storable commodities. There’s no limit to how spreads can vary in either direction for perishable commodities such as live cattle.
You should be aware that, you can “leg off” a spread, meaning you can liquidate one side and leave the other intact, but it’s generally not a good idea. You generally enter a spread as a spread because it’s a lower-risk transaction.
Novice traders, when a spread isn’t working to form, have been known to take off the profitable leg, leaving the unprofitable on, hoping it will come back and profits can be realized on both sides. For some unexplained reason, this usually doesn’t work. (It would be better in most cases to take off the unprofitable side, since this is the side that isn’t working).
But no matter which side you take off, if you exit one side of a spread you’re immediately incurring the risk of an outright transaction. It’s sort of like splitting sixes in Blackjack because you don’t like a 12 against a dealer’s ace. While it may work at times, in most situations you’re just asking for trouble.
Incidentally, if you leg off a spread you immediately lose your margin advantage, and your account will be charged full margin for the remaining outright position.
I’ll end this particular discussion of spreads with a caveat. Since the margins are generally much lower on spreads, there’s a natural tendency to over-trade, that is to put on too many. Just because spreads are limited-risk doesn’t mean there isn’t risk, and on occasions they can entail a greater risk.
A number of years ago, a friend of mine had on the long July/short December cotton spread. Some change in government policy was announced one afternoon after the market’s close. While I forget the specifics, I do remember the next day the market opened limit down in the July and limit up in the December, the result being he was hit to the max on both sides.
Trade of the Month
The Trade of the Month is a popular intermarket spread: Buy September Wheat/Sell September Corn.
Recently this spread has been trading either side of $1.80 wheat over (above) corn. So what’s a “normal” spread? Normally, wheat will trade above corn. However, the premium can vary dramatically from year to year.
For example, in 2007 corn prices surged to all-time highs due to insatiable demand for ethanol production, and wheat at one point was trading at only 70 cents over corn.
September 2007 Wheat-September 2007 Corn
Source: Commodity.com
At the other extreme, last year due to crop failures in certain wheat producing countries wheat at one point was trading as high as $6.60 over corn.
September 2008 Wheat-September 2008 Corn
Source: Commodity.com
As we go to press, September wheat is trading at $1.80 to $1.90 over September corn. So this year’s wheat-to-corn spread can’t be considered very high or very low from a historical basis.
Here are the three market pillars that outline why I anticipate wheat will gain on corn over the coming months, with a price objective of $2.50 wheat over corn.
The Seasonal. The “Voice from the Tomb” (discussed at length in my book) tells us to be a buyer of wheat on July first. This is a seasonal play based the fact that early July is many times a major bottoming point for the wheat market.
Many farmers sell their wheat right out of the fields to raise cash at harvest time. At this time the harvest has just passed the half-way mark nationally, and harvest selling pressure will start to wane as the summer unwinds.
The Fundamental. Last week the US Dept of Agriculture released an important acreage report that shocked the trade with a huge corn acreage figure 3 million higher than estimates.
What this means is, barring a weather problem this summer, the new corn crop will replenish supplies that should adequately meet the demand this coming year.
Wheat stocks in the US are about the same as last year; however, with record-low production in the important wheat-growing country of Argentina, demand for US wheat should rise. (Exports are more important for US wheat than domestic usage.)
The Technical. The September wheat-corn spread, although volatile, has been registering a series of higher highs and higher lows since last April.
The technical trend has turned up, and the June collapse from the last higher high (above 240) appears to me to be a trading opportunity.
September 2009 Wheat-September 2009 Corn
Source: Commodity.com
We can enter the spread now with a reasonable risk point, just below the trendline in the low 160s. The potential is a move above the early June high, and a move to 250 would result in a profit from current levels of over $3,000 per spread traded.
If you have an interest in participating in this feel free to email me at geo@commodity.com and we can discuss it.
As always, I wish you a profitable trading experience.
For additional trade recommendations, consider George Kleinman’s subscription-based service, Futures Market Forecaster. And be sure to check out George’s new book, The New Commodity Trading Guide, available now at Amazon.com.
Risk Disclaimer
Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the “Holy Grail.” Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.
Hypothetical Performance
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
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