Trading Commodity Spreads
Many professional commodity traders focus on trading spreads. A spread involves the simultaneous purchase of one commodity and sale of the same or a similar commodity. Spread positions tend to be less risky than outright long or short commodity positions.
Some of the more traditional spreads are in the grain markets. A common trade is to buy one grain and sell another grain. For example, a trader might buy December corn and sell December wheat. The premise for the trade is that the trader expects the corn market to be stronger than the wheat market. As long as corn moves up more than wheat or doesn’t fall as much, the trader will make a profit.
Spreads are also common within the same commodity. For example, a trader can buy July corn and sell December corn at the same time during spring; this is an example of a bull spread. The front-month typically moves more than the further out or deferred months. If someone expects corn prices to move higher during the year, this would be a trade that supported this market view.
Corn prices can be volatile, while spreads usually only move a fraction of what transpires in the outright price. Spreads are a more conservative strategy than outright long or short positions in futures contracts. The margin requirement for spreads tends to be much lower than it is in a straight long or short futures contract position.
Types of Commodity Spreads
A trader can find almost any kind of commodity spread to meet an outlook in the market. Types of futures spreads include:
- Intra-Market spread: This is commonly called a "calendar spread." It involves buying and selling different contract months within the same commodity. For example, a trader can buy May soybeans and sell November soybeans.
- Inter-Market spread: This type of futures spread involves buying and selling different but related commodities. The commodities tend to be correlated, but there may be reasons why one commodity could be stronger than the other. For example, a trader could buy silver and sell gold.
- Inter-Exchange spread: This spread involves the simultaneous purchase and sale of the same underlying commodity that trades on different exchanges. An example is buying December wheat futures traded on the CME Group and selling December wheat futures traded on the Kansas City Board of Trade.
Trading Commodity Spreads
Traders are highly sensitive to the price spread between two contracts, which is the difference between the two contracts. For example, July corn is trading at $6.05, and December corn is trading at $5.75. The spread is 30 cents. If July corn moves up faster than December corn, the spread will increase. In this case, buyers of the spread will make a profit.
Spreads can be a more conservative way of approaching markets, but that does not mean they are risk-free. Anyone who has traded spreads over a period knows that things can sometimes go awry. Weather conditions and crop reports are examples that can cause spreads to move dramatically.
A worse case scenario is when the futures contract you buy moves sharply lower and the contract you sell moves sharply higher. Two correlated commodities like corn and wheat often diverge. It is not a good feeling when you are looking for a five-cent gain on a spread, and overnight you lose 15 cents because of crop news from China. On any trade, spread or outright, one must always be aware of the risks even when employing a more conservative strategy.
More About Spreads
There are so many different types of spreads to trade when it comes to the commodity markets. Some other spreads are:
- Location spread: Buying and selling the same commodity for delivery in different locations (e.g., long gold for delivery in New York versus short gold for delivery in London)
- Quality spread: Buying and selling the same commodity but of a different quality or grade (e.g., long Arabica coffee versus short Robusta coffee)
- Processing spread: Trading a long or short position in one commodity against the opposite position in a commodity that is the product of the other side of the trade (e.g., long crude oil versus short gasoline)
Spreads tend to have lower margin requirements than outright long or short positions, but they can be riskier than an outright long or short position at times.