In our article Use of the Term “SPREAD” in Exchange Trading we briefly introduced the area of commodity spreads, or rather futures spreads. Let's now look at them in more detail.
The principle of trading futures spreads is a speculation on increase or decrease of price difference between two futures contracts. This means it is not a traditional speculation on a price increase or decrease of a certain commodity or an underlying traded as futures. Commodity spread trading is based on speculation on the price difference (or the price range) between two futures contracts of the same commodity/underlying with different expiration months, or the price difference between different commodity or futures contracts, or even the price difference between different commodities traded on different exchanges.
Commodity spread trading belongs to hedging strategies which are used for minimising trading risks. Hedging is actually the very basic essence of futures trading which allows traders to fix prices of commodities that they produce or, vice versa, commodities that they need to buy for their business activities. Futures thus allow them to secure a price of their commodity.
The situation is different in case that we belong to a group of traders who are not interested in actual purchase or sale and a subsequent delivery of a physical commodity. Such a group of traders only speculate on an increase or decrease of the commodity price. In order to hedge our open positions and reduce our trading risk it is possible to open a second position, for example in the same commodity, but with a different expiration date. For example, when buying a soybean contract with expiration in July 2014, we speculate on increase of soybean contract price. If the market began to turn against us, we could cover our position against a potential loss, it means to reduce our loss or even turn it into profit by opening a short position in the same market, but with a different expiration month. In our case we could open a short hedging position in soybean market with expiration in March 2014. Thus, if the price of long naked position began to go down, our profit would decrease or we could even end up in loss. On the other hand, if we opened a covering short position, which itself would generate profit in the declining market, the loss from the long position would get neutralised by the profit from the short position.
Commodity spread trading is a specific trading approach based on principles of covered positions. However, in this case, we do not aim to "rescue" an endangered trading position. Commodity spread trading strategy is based on opening both long and short positions at the same time. We then speculate on a profit coming from the price difference between the two contracts. This implies that in spread trading we use so called combo positions. A spread positions therefore always consist of two trading positions that get open at the same time. In trading terminology they are called legs. If we bought a spread (long spread position) we would profit from increase of the price difference between the two spread legs. Such a price difference gets displayed in specific spread charts. These charts do not include prices of the individual legs but they only show their price difference.
As we have already explained in our previous article, there are 4 types of commodity spreads:
The first chart shows a heating oil futures contract with expiration in February 2014. The chart on the right shows the same market but with expiration in January 2014. The LAST price of the February contract is $ 3.0646. And the LAST price of the January contract is $ 3.0651. The difference in price, i.e. spread, is $ 0.0005. And below you can see the chart of the price difference, it means the spread chart. The spread has a growing tendency and therefore many traders opened long combo positions after the double bottom pattern confirmation.
In this article we explained what are commodity spreads or futures spreads and how they can be used in trading. In the following articles we will address the advantages of this trading approach. If you were interested in practical mastering of this profitable trading approach, subscribe to our Course of Commodity Spread Trading.
The charts used in this article were generated in the SeasonAlgo platform. This platform represents a unique tool for trading both commodity spreads and outright futures contracts. If you want to learn how to work with this platform, you can order our on-line Course of Using the SeasonAlgo Platform or you can order the individual course.
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