Spread Trading

By Jim Wyckoff

Spread trading in futures markets does not get a lot of attention among speculative traders. However, many traders do employ this method of trading because it can be less risky and less expensive than trading straight futures contracts. It is beyond the scope of this article to provide all the specifics of how to spread trade. However, this feature will introduce you to the concept and define some of the terms used in spread trading. I have a book called “Commodity Spreads” by Courtney Smith that I have used for reference. It is published by John Wiley & Sons in New York.

First, let’s define spread trading: It is the simultaneous purchase of one futures contract and the sale of a different contract. The futures contracts can be different delivery months in the same commodity; or they can be two different commodities spread against each other. Or, they can be the same commodity traded on two different futures exchanges. The spread trader becomes simultaneously long one futures contract and short one futures contract. A spread is composed of two “legs.” One leg is the long contract position and the other leg is the short contract position.

A spread that is between different contract months in the same commodity is called an interdelivery spread. A spread between two different commodities is called an inter-commodity spread. Traders try to profit from spreads by the price difference between the two contracts. The spread trader is more concerned with the relative price between the two contracts, as opposed to the absolute price of the commodity.

Large commercial firms are often large spreaders and analyze and utilize commodity spreads in many different ways. Large speculative firms (the funds) also employ spread trading. The smaller speculators—the individual traders—are the least frequent users of spread trading. This is because of the complexity that tracking and analyzing some spreads can entail. However, there are simpler spread-trading techniques that individual traders can employ. It has been said that most spread traders rely heavily on fundamental analysis when employing their spread trades, while most speculative traders of straight futures rely more heavily on technical analysis.

As I said in the first paragraph, spread trading usually involves less risk than trading straight futures. Because storable commodities have “carrying charges,” spreads rarely go beyond a certain level that is known to veteran spread traders. This means a trader can initiate a spread and know to a fairly certain degree how mush risk is involved. There are some spreads that do involve higher volatility, such as inter-commodity spreads. Also, due to lower risk involved, margins required by brokers are less than margins required when trading straight futures.

Inter-delivery spreads are categorized as a “bull spread” or a “bear spread.” A bull spread is when a trader is long the nearby contract and short the deferred contract within the same commodity. The trader who puts on a bull spread is looking for the nearby contract to be stronger (price will rise faster) than the deferred contract. Conversely, if the price is falling, the bull
spreader is looking for the price of the nearby contract to decline to a lesser degree than the deferred contract. And, there is always the possibility that the nearby futures price will rise and the deferred contract price will fall. The bear spread is the reverse of the bull spread. The trader is short the nearby futures contract and long the deferred contract in the same commodity. The bear spreader is looking for the deferred contract to be the stronger mover up in price than the nearby, or the nearby contract to decline in price faster than the deferred. Bull and bear spreads can be used as a substitute for outright positions in a market. The advantage is less volatility and lower margin costs. The disadvantage is that spread trading does not usually accrue the amount of profit that is possible on a per-contract basis as does straight futures trading, when the market does move in your favor.

A special type of inter-commodity spread is the spread between a commodity and its products. A very common spread is the “crush spread” between soybeans and its products, soybean meal and soybean oil. This spread is considered to be a complex spread. Very few soybeans are used just as soybeans. Nearly all soybeans are crushed into two products, meal and oil. A soybean crusher makes his profit from the difference between the cost of buying the beans and the price of selling the products. This is called the “crush margin.”

Commodity spreads can be a valuable tool to the trader of outright futures who does not spread trade. For example, if the nearby futures contracts for corn are gaining in price relative to the deferred contracts, this generally indicates more demand or less supply, or both. It’s a strong signal that fundamentals are bullish and prices may well move still higher. However, if the nearby corn futures do not gain on the deferreds during an upmove, then the trader may surmise that the recent price advance has been technical in nature and not backed by bullish fundamentals, and that a sell off may be close at hand.

By looking at the spreads, a trader can also see which contract is trending the strongest, and decide to trade that contract as opposed to others that may not be trending as strongly.

Again, this feature just scratches the surface of spread trading in the futures markets. If you are interested in trading spreads, then I suggest reading a book or two on the subject.

The author, Jim Wyckoff, can be contacted at 319-277-8643 or via email at jim@jimwyckoff.com