SPREAD TRADING
A spread is the simultaneous purchase and sale of the same or similar commodity in the same or different contract months. Spread trading is usually considered to be a lower risk strategy than an outright long or short position, and therefore margin requirements are usually much less than an outright long or short position.
For example, if the price trend of soybeans is currently up and you are in a soybean spread, (short one month and long another) the gain on the long position would likely offset the loss of the short position, and vice-versa. One side of the spread typically hedges the other, therefore the lower margin requirements. Keep in mind that spreads are not guaranteed to be less risky, there is risk of loss in all trading.
Just like with any commodity a spread can be bought and sold at “x” price, and it can be charted just like any other market. What is being plotted…simple…the difference between two contracts. A typical spread chart looks like this:
You must be asking “How do I make money if I am long and short the same commodity?” The answer is you are hoping to profit from the difference in the two contract months, not from a trend higher or lower in any particular market. With a spread, you follow the relationship, or difference between the contracts, without having to pick a market direction.
For example, if July Soybeans were trading at $5.10/bushel and November Soybeans were at $5.35 the spread would be said to be at .25 to the November side. If you entered a July/November bean spread, you would simultaneously buy a July and sell a November contract.
If soybeans rallied, what would happen?…
Well, let’s say July settled one day at $5.70 and November settled at $5.75, the spread would now be .05.
So how would the P&L look?
In this example July rallied 60 cents (you were long a July contract so you made 60 cents on it) and November rallied 40 cents (you were short a November contract and lost 40 cents on it), you would have a net gain of 20 cents on the spread.
The above example is known as an intra-commodity spread, buying one month and selling another in the same commodity. An inter-commodity spread is buying a commodity month in one market, and selling another related commodity in the same or similar month.
Some of the advantages of spreads are:
- typically require smaller margin deposits
- underlying market direction isn’t important
- seasonal patterns exist among spreads