Futures Spread Trading has traditionally been known as a professional’s trading strategy. However, we feel it is a trading method that should be in everyone’s arsenal. Our goal here is to layout the basics of spreading so you will have a solid foundation of knowledge in this essential trading strategy.
Types of Commodity Futures Spreads
Inter-Commodity Futures Spread
Futures contracts that are spread between different markets are Inter-Commodity Futures Spreads. One example of this is Corn vs. Wheat. Let’s say the trader thinks that the Corn market is going to have higher demand than the Wheat market. The trade would buy Corn and sell Wheat. The trader does not care if the prices of Corn and Wheat go up or down; the trader only wants to see the price of Corn appreciate over the price of Wheat. If the grain markets sell off, the trader wants to see Corn hold its value better than Wheat. If the grain markets are bullish, the trader wants to see Corn advance farther than Wheat.
Intra-Commodity Calendar Spread
An Intra-Commodity Calendar Spread is a futures spread in the same market (i.e. Corn) and spread between different months (i.e. July Corn vs. December Corn). The trader will be long one futures contract and short another. In this example, the trade can either be long July Corn and short December Corn OR short July Corn and long December Corn. In order to be in an Intra-Commodity Calendar Spread, the trade must be long and short the same market (i.e. corn) but in different months (i.e. July vs. Dec)
Bull Futures Spread
A Bull Futures Spread is when the trader is long the near month and short the deferred month in the same market. Let’s say it is February of 2011. You buy May 2011 Corn and sell July 2011 corn. You are long the near month and short the deferred month (May is closer to us than July). It is important to note that the near months for futures contracts tend to move farther than faster than the back months. If corn is in a bull market, May (near month) should go up faster than July (deferred month). That is why this strategy is called a Bull Futures Spreads. Since the front months tend to outperform the deferred months, a trader who is bullish on corn would buy the near month, sell the deferred month, and would like for the near month to move faster and farther than the deferred months.
This relationship between the near and deferred months is not always true 100% of the time, but it is the majority of the time. That is why when you are long the near month and short the deferred, it is called a bull futures spread. The spread should go in your favor when prices are rising.
Bear Futures Spread
A Bear Futures Spread is when the trader is short the near month and long the deferred month. This is the opposite of our Bull Futures Spread. Again, let’s say it is February of 2011. You sell May 2011 Corn and buy July 2011 Corn. You are short the near month and long the deferred month. This is a bear spread because the near months ten to move faster and farther than the deferred months. If Corn is in a bear market, May (near month) should go down faster than July (deferred month). This is not always true 100% of the time, but it is the majority of the time. That is why when you are short the near month and long the deferred month, it is called a Bear Futures Spread. This spread should go in your favor when prices are declining.
Futures Spread Trading Margins
Margins for individual contracts may be reduced when they are part of a spread. The margin for a single contract of corn is $2025. However, if you are long and short in the same crop year, the margin is only $200. If you are long or short corn between different crops year (July vs. Dec) then the margin is $400. The crop year for corn is December through September.
The exchanges reduced the margins because the volatility of the spreads is typically lower than the actual contracts. A futures spread slows down the market for the trader. If there is a major external Corn market event, like the stock market crashes, the fed raises interest rates, a war breaks out, or a foreign country defaults on its bonds half way across the earth, both contracts should be affected equally. It is this type of protection from systemic risk that allows the exchange to lower the margins for spread trading. If you would like to know more about how Spread Trading hedges against Systemic Risk, please read my previous article, “Hedging Systematic Risk”
Futures Spread Pricing
Spreads are priced as the difference between the two contracts. If May Corn is trading a 600’0 a bushel, and July is trading at 610’0 per bushel, the spread price is 600’0 May – 610’0 July = -10’0. If May was trading at 620’0 and July was 610’0, the spread price is 620’0 May – 610’0 July = +10’0.
Futures Spread Quotes
When pricing spreads, you always take the front month and subtract the deferred month. If the front month is trading lower than the deferred (like our first May vs. July example), the spread will be quoted as a negative number. If the front month is trading higher than the deferred month (like our second May vs. July example), the spread will be quoted as a positive number.
Futures Spread Tick Values
Tick Values are the same for spreads as they are for the individual contracts. If the spread between May Corn and July Corn is -10’0 cents, and the spread moves to -11’0 cents, that is a 1 cent move. 1 cent in corn is $50 for all months and spreads in the standard 5000 bushel contract. The tick values are the same for spreads as they are for their individual contracts.
A market is in Contango when the front months cost less than the deferred months. This is also known as a “normal” market. If a bushel of corn in May costs 600’0 and a bushel of corn in July is 610’0, that market is in Contango. In normal markets, the deferred month should cost a little more than the front month due to the cost of carry, which is made up of storage costs, insurance on stored commodity, and interest rates payments for the capital needed to own and store the commodity.
When markets are in Backwardation, the near months are trading higher than the deferred months. Markets in Backwardation are also called ‘inverted” markets. They are the opposite of Contango or “normal” markets. Backwardation typically occurs during bull markets. When there is a substantial supply issue or increase in demand, the front months of a commodity will start to go up faster than the back months. The front months are more sensitive to changes in supply and demand because the front months are the commodity months that are coming to the market for deliveries. If there are supply decreases or demand increases, it is easier for the market to account for these in the deferred months, especially in the next crop year, also known as the “new crop”.
For example, let’s say it is February of 2011 and there is a shortage of corn. The “old crop” months are March, May, July and September. The “new crop” starts in December. There is not much the market can do about the supply from March to September, when Corn is being planted, grown and harvested. The corn that is made available during these months is coming out of stocks and storage. However, the market does have some control over December and the months going into 2012, like using more farming acres for Corn.
New acres devoted for corn will help the new crop keep prices stabilized for the deferred months. The near months will still increase because corn can not be harvested until the fall, but the deferred months should be able to help with demand and will not go up as fast as the near months.
Futures Spreads and Seasonality
Many commodities markets have seasonal periods of supply and demand. Some commodities are in higher demand during the summer, like Gasoline and Crude Oil, while some have a higher demand in the winter, like Natural Gas, Heating Oil and Coffee. Commodities also may have seasonal periods of supply, like the grain markets. The Corn market has the greatest supply right after harvest in the fall, which can lead to lower prices during that time of year.
Traders will use spreads and try to take advantage of these seasonal supply and demand changes. They look at the performance of spreads over the year during specific time frames to estimate the risk, reward, and probability of success. If you would like to know more about Seasonal Futures Spread Trading please read my previous article, “Seasonal Futures Spread Trading”
Finally, if you like this post, you may also like my article “The Wonderful World of Futures Spread Trading”.
Spreads Risk Disclosure: A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts. It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread). In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.