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 (buy) or short (sell) 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. When traders sell a commodity, they're betting that it will decrease in price, so they sell it, wait for the price to drop, and buy it for less to close out the position and make a profit.
- By buying one commodity futures contract and selling a similar one, traders can limit their risk.
- When trading a spread on the same commodity, the two futures contracts may be differentiated by time (buying a November contract and selling a December one) or by exchange (buying a contract on one exchange and selling a contract on another).
- Spreads can also be traded across slightly different commodities, such as by buying crude oil contracts and selling gas contracts.
- Despite being a relatively conservative trading strategy, there is still risk involved with commodity spreads.
The Premise of Commodity Spreads
The premise for the spread 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 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.
A More Conservative Approach to Markets but Not Risk-Free
Traders are highly sensitive to the price spread between two contracts, which is the difference between the two contracts. For example, say that July corn is trading at $6.05, and December corn is trading at $5.75, making the spread 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 completely risk-free. Anyone who has traded spreads over a period of time knows that things can sometimes go awry. Unforeseen weather conditions and crop reports are examples of issues that can affect the price of commodities and cause spreads to move dramatically.
A worst-case scenario is when both sides of the spread move in a money-losing direction. For example, say that 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.
There are many different types of spreads you can trade when it comes to the commodity markets. Some other examples of spreads include:
- 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 Robusta coffee short)
- 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.