COMMODITY FUTURES-SPREADS



Commodity futures spreads, often simply called spreads, are one of several basic strategies that futures traders use to make a profit. (The term is also used generally to describe the difference between an asking price and a bid on securities and other financial instruments.) In its simplest form, a futures spread takes place when a trader buys one futures contract while simultaneously selling another, in hopes of making a profit through a favorable difference in prices during the coming weeks or months. That difference is known as the spread. A profit can be made between the opposing market positions in two ways:

  1. Buying the spread. When an investor expects that the price difference between two contracts will widen, he buys the spread by taking futures positions that would allow for the greatest growth in the spread.
  2. Selling the spread. Conversely, if the spread is expected to diminish, that is, if prices of the two commodities are converging, the investor sells the spread by assuming market positions that would allow for the greatest decrease in the spread (see the examples below).

Although these are the essential strategies, more complex spreads may involve trading options or taking more than two positions in the market. Spread trading differs from outright trading, where a trader takes only one position in the market (i.e., buying or selling, but not both).

Spreads are often considered less risky than an outright trade, but the tradeoff is that they also tend to be less profitable than staking a single position on the market. Usually, one of the contracts is expected to make enough profit to offset losses on the other. Therefore, the margin requirements, the funds needed to initiate a spread position, are lower than what is required for an outright trade. These low margins help traders using spreads realize higher returns on capital than they often can in outright trading. But spreads are hardly risk-free. Since each side, or "leg," of the spread may be negatively affected by fundamental or technical factors in the markets, the widening or narrowing of a spread may exceed the broader average movement in the market. As with other kinds of futures transactions, it is likewise possible to make a profit with spreads when the cash markets (as gauged by the Dow Jones Industrial Average, the S&P 500, and other indicators) suffer a downturn.

Four kinds of relationships may exist between each leg of the spread. First, spreads between different delivery months for the same commodity (for example, buying and selling wheat) are known as intracommodity or interdelivery spreads. Second, juxtaposing two different commodities, such as gasoline and heating oil, is known as intercommodity spreading. Third, an intermarket spread is the buying and selling of similar commodities on different markets, such as buying oil futures on the New York Mercantile Exchange and selling on the International Petroleum Exchange. And fourth, supply-chain, or source-product, spreads combine commodity positions on two different stages of production, as in buying crude oil futures and selling gasoline contracts. Of the four types, intracommodity spreads tend to be the most conservative positions, while intercommodity spreads are apt to carry the most risk because they are exposed to wider and less predictable market influences.

A trader interested in spreading doesn't have to start from scratch looking for price relationships that would offer a lucrative spread. Certain types of spreads are traded so routinely that they have nicknames and somewhat predictable—although by no means guaranteed—results. These include the U.S. Treasury bill/eurodollar spread (known as the Ted), the heating oil/gasoline spread (known as the gasoline crack spread), and the corn/wheat spread. Recurring market forces such as economic cycles and high-demand/low-demand seasonality help to make these spreads perennial investment vehicles.

EXAMPLE OF BUYING THE SPREAD

As an example of an intracommodity spread, say a trader anticipates that the price difference between March and May wheat futures will widen. When there is no anticipated shortfall in supply, the deferred contract (in this case, May) tends to have a higher price than the more immediate contract (March). Thus, March wheat may be trading at $3.50 a bushel, while May wheat may be going for $3.55 a bushel. This creates an initial spread of $0.05 per bushel between the two trading months.

Since the trader expects that spread to grow, she sells a contract (one contract equals 5,000 bushels) for the lower price (March) and buys one contract for the higher price (May). In market terminology, she has taken a short position in March and gone long on May; she has therefore bought the spread, as these positions combine to allow for maximum growth in the spread. As March nears and she is ready to extinguish her contracts, both months' prices have risen, but as the trader predicted, May has risen faster. The March contract is now worth $3.60 per bushel, and the May contract has climbed to $3.75, bringing the spread to $0.15 per bushel. At 5,000 bushels, this increase of ten cents in the spread translates into a $500 profit ($0.10 × 5,000) between the transactions. Analyzed separately, the March contract was sold at $3.50 per bushel, totaling $17,500, and bought back at $3.60 per bushel, or $18,000. This produced a $500 loss, or ten cents per bushel, on the short position. Meanwhile, May wheat was bought for $3.55 a bushel ($17,750 total) and sold for $3.75 ($18,750 total). That left a $1,000 profit on the May contract to offset the $500 loss on March and, hence, yielded a net return of $500.

EXAMPLE OF SELLING THE SPREAD

Profits can also be made when the spread narrows. Consider a hypothetical example of an intermarket spread on municipal bonds (munis) over Treasury bonds, commonly known as the MOB spread. A trader learns that, although bonds in general tend to move in the same direction, historically for September futures, the price of municipal bonds has often risen in relation to U.S. Treasury bonds. This signals a declining spread, since the prices of the two contracts are expected to move closer. The trader decides to test this pattern by selling the September MOB spread in July.

To do so, he buys a municipal bond futures contract at 124 18/32—read as 124 points and 18 ticks—and sells a Treasury bond contract at 126 18/32, for an initial spread of 2 points. In this price notation, each point is worth $ 1,000 and each tick is worth $31.25. Put another way, the futures contracts are worth $1,000 times the quoted price in decimals, so the investor has bought a muni contract for $124,562.50 and sold one for $126,562.50. After two weeks, the spread has indeed decreased, although not quite as the investor expected. The muni has actually lost a bit of value, retreating to 124 2/32, but the T-bond has decreased as well, to 125 24/32, thus narrowing the spread to 1 22/32. This results in a net decrease of 10/32 (10 ticks) in the spread, representing a profit of $312.50 (10 ticks × $31.25 each) between the two positions. By individual contract, his net return is calculated as follows: on the muni contract, he lost $500 (124 2/32 - 124 18/32 = minus; 16/32 = minus;16 × $31.25), but on the T-bond he has gained $812.50 (126 18/32 minus; 125 24/32= 26/32 = 26 × $31.25). After subtracting the loss, this leaves a return of $312.50.

SEE ALSO : Arbitrage ; Commodities ; Commodity Exchanges ; Futures/Futures Contracts

FURTHER READING:

Evans, Tim. "Gasoline Crack Spread: A Safer Seasonal Trade." Futures, February 1997.

Futures Industry Institute. "Hedging and Spreading." Introduction to the Futures and Options Markets. Washington, 1998. Available from www.fiafii.org/tutorial/toc.htm .

Thachuk, Rick. "Spreads: Unlocking Hidden Profits." Futures, November 1998.



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