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. If you are going to follow along with Swine Times recommendations from a speculative perspective, you will need to understand this. We will take directional positions in a market, but for margin and other reasons we rely on spreads. Our goal here is to layout the basics of spreading so you will have a solid foundation of knowledge in this essential trading strategy.
Intra-Commodity Calendar Spread
An Intra-Commodity Calendar Spread is a futures spread in the same market (i.e. Hogs) and spread between different contract months (i.e. February Hogs vs June Hogs). The trader will be long one futures contract and short another. In this example, the trade can either be long (we buy) February Hogs and short June (we sell simultaneously). In order to be in an Intra-Commodity Calendar Spread, the trade must be long and short the same market but in different contract months.
Bull Futures Spread
As you follow along, and you see us buy a closer dated contract while selling a further dated contract, you can assume we are bullish. A Bull Futures Spread is when we are long the near month and short the deferred month in the same market. For example, it is November as this guide is published. If we feel product markets are going to rally in the short term, we might look at buying December Hogs and selling a deferred contract like the April Hogs. You are long the near month and short the deferred month (December futures are closer to us in time than February). When we feel a market like pork bellies will rally on increased demand, we may look to “bull spread” Lean Hog futures in this fashion with the idea that the December futures are going to go up faster than the February futures. Maybe supply is higher in February than December, so price will encourage producers to move supply forward to capture that gain. For example, December price will go up in value by 1.00 while February only goes up 50 cents; and because we are long December, we make 1.00 while we lose .40 in the February. The outcome is a .60 cent profit before fees (or loss if the opposite would occur).
Bear Futures Spread
If you see us do the opposite of the example above, you can assume we are bearish the market. A Bear Futures Spread is when the trader is short the near term contract month and long the deferred contract month. Just reverse the example above. Let’s say we believe through our research that the packer is operating with negative profit margins. In this case, we would sell the front month December futures contract and buy the deferred April contract. Price will work to encourage to ration supply meant for front month delivery and discount the front of the curve vs the back. Let’s assume December futures are trading at 65.00 when we sell or short that contract, while April futures are trading at 70.00 cents. Over the next few days, December futures fall 3 cents to 62.00 cents while April futures only fall to 68.50 cents. We profit 3 cents on the short contract while losing 1.5 cents on the deferred contract. The outcome is a 1.5 cent gain on the combined position before fees (or loss if the opposite would occur).
Why would we trade the spread instead of just buying or selling one outright position? A couple of reasons. The first is by getting a margin discount. As of time of publishing, margin of one net long or short futures contract in hogs is $1200 per position, while the margins (depending on the contract month legs) are around $900 per spread position. If the market for hogs would evaporate as a whole, both contracts would fall. Since we own one and would be short the other, we could still lose money but we feel more comfortable in a spread than in an outright futures position. Which brings us to another advantage, spreads can help insulate you against systemic risk. Under ideal market conditions, a futures spread can reduce the effect of daily market volatility for the trader, thus slowing down the market. If there is a major external Hog market event – 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 somewhat equally. However, some events could multiply volatility thus allowing both positions to move against you. If you would like to know more about how Spread Trading hedges against systemic risk, please read a previous Daniels Trading article titled, Hedging Systematic Risk
Other Terms To Know in Futures Spread Trading
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 hog contract in December in costs 62.00, February costs 64.00 and April costs 65.00 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 in most commodities. When there is a substantial supply change expected 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 more exposed to commodity funds who speculate in the trade along with events happening in the short term. If there are supply decreases or demand increases, it is easier for the market to account for these in the deferred months.
Keep in mind, hog markets are different than markets like corn or wheat as they are dealing with actual living product that has daily needs to survive. Hogs get sick, they gain and lose weight as weather changes, as the price changes producers may need to liquidate or suddenly produce more which would have repercussions for other contracts. It is the goal of the Swine Times to profit from these events.
The Swine Times
The Swine Times is a newsletter and trading program designed for futures traders who are looking to diversify from outright long/short trading in commodity markets. Supply and demand dynamics change throughout the year. A big part of the strategy of the Swine Times trading program attempting to take advantage of those changes by buying one contract month while simultaneously selling a different contract month. Hopefully this guide has explained some of that. Please feel free to contact us if you have any questions.
If you have any interest in learning more about this product or the publishers, check out us out HERE.
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The Swine Times - The Swine Times newsletter is designed to help participants in the pork complex understand and trade the futures markets. Our intention is to fundamentally inform and trade based off the information we have.
Guide to Futures and Spread Trading
This comprehensive ebook, compliments of Guy Bower, is designed to help you understand and master the fundamentals of futures spread trading.
This material is conveyed as a solicitation for entering into a derivatives transaction.
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