Bull and Bear Spreads in Commodities

When someone is bullish on the price of a commodity, it is the view that the price will move higher. Conversely, a bearish opinion is the belief that the price will move lower. Market participants, traders and investors, have a number of different tools at their disposal to position accordingly depending on a market view. Bull spreads and bear spreads are two such vehicles. However, these spreads can consist of different market vehicles and have their own particular idiosyncratic characteristics.

If someone is bullish on the outright price in a commodity, they can buy the physical asset or derivatives to make money if correct in the market view. The futures market provides the easiest and most liquid method of expressing a bullish opinion. Buying, or going long, outright futures contracts is a position that has unlimited profit potential but at the same time it has unlimited risk. To limit risk, a long call option will express a bullish view. In this case, the profit is unlimited so long as the price moves above the strike price of the option and the premium paid. If the price moves lower, the loss is limited to the premium paid for the call option. To limit the risk of loss even further, a vertical bull call spread is available. In this case, the bullish party will buy a call option and simultaneously sell the same quantity of another call option with the same maturity that is further above the current market price than the one purchased.

 In this case, the profit is limited to the difference in the strike prices minus the premium paid for the bull call spread.

If someone is bearish on the outright price in a commodity, they can sell physicals or derivatives to make money if correct in the market view. The futures market provides the easiest and most liquid method of expressing a bearish opinion.

Selling, or going short, outright futures contracts is a position that has unlimited profit potential but at the same time has unlimited risk. To limit risk, a long put option will express a bearish view. In this case, the profit is unlimited (of course the price can only go to zero) so long as the price moves below the strike price of the option and the premium paid. If the price moves higher, the loss is limited to the premium paid for the put option. To limit the risk of loss even further, a vertical bear put spread is available. In this case, the bearish party will buy a put option and simultaneously sell the same quantity of another put option with the same maturity that is further below the current market price than the one purchased.  In this case, the profit is limited to the difference in the strike prices minus the premium paid for the bear put spread.

These spreads are debit spreads because they cost money. In both cases, a market participant can sell these spreads (the bull call spread or the bear put spread) to achieve the opposite effect. When they sell, they will collect premium, as the spreads are credit spreads.

There are other types of bull and bear spreads as well.

These spreads involve a view on not just outright price moves but movements in term structure, or the price differentials between months for a commodity market. Backwardation is a market condition whereby deferred prices are lower than nearby prices. Backwardation implies a supply shortage. Buying the nearby futures contract and simultaneously selling the deferred futures contract in the same commodity is a bull spread in futures. This spread makes money if the backwardation widens or nearby prices increase more than deferred prices. This tends to happen when a supply shortage worsens.

A bear spread on futures involves selling the nearby futures contract and simultaneously buying the deferred contract. Contango is a market condition whereby deferred prices are higher than nearby prices. Contango implies a market in equilibrium or oversupply.

The bear spread in futures makes money if the contango widens or deferred prices move higher than nearby prices. This tends to happen when a market glut increases. Both of these futures spreads are intra-commodity spreads, time or calendar spreads and express a market view on supply and demand.

In the world of commodities, the futures market offers many ways for market participants to express their bullish or bearish views on price or on supply and demand. Bull and bear spreads are tools used by many of the most sophisticated and clued in traders in the world.