What is Commodity Spread Trading?
Spread trading involves taking opposite positions in the same or related markets. A spread trader always wants the long side of the spread to increase in value relative to the short side. This means the spread trader wants the difference between the spread to become more positive over time. Whenever a spread is quoted, it’s always a single price. You would never get a quote with the two individual prices. The price is figured by subtracting the back month from the front month. For a more in-depth explanation, please visit our Introduction to Spread Trading page.
Commodity Spreads Can Offer Lower Risk
Commodity futures spreads are a lower risk approach to trading commodity futures that can be utilized by traders of all levels of experience. Commodity futures spreads are less sensitive to market moves than a pure commodity future position, and can provide a more conservative addition to an existing futures trading portfolio.
We are going to delve in detail into commodity futures spreads and explain a range of key commodity spread trading strategies that traders can utilize to effectively trade the commodity futures market.
Commodity Spread Strategies
What is Contango?
A market is regarded as being in Contango when the value of the forward contract is higher than its spot price or the price of a contract expiring in an earlier month is lower than the price of a contract expiring in a latter month (yielding in an upward sloping curve). In such conditions the market is said to be ‘normal’.
What is Backwardation?
A market is in backwardation when the value of the forward contract is lower than its spot price or the price of a contract expiring in an earlier month is higher than the price of a contract expiring in a latter month (generating an inverted sloping curve). In such conditions the market is said to be ‘inverted’. This typically happens in bull markets, and when there are shortages of the commodity and/or increased demand. This is because the nearer months are up for delivery earlier while prices are high because of demand supply imbalances, with the expectation that these conditions will ease closer to the latter delivery months.
Corn Contract Example of Backwardation
For example, let us say in February 2018, a March 2018 corn contract is priced higher than a December contract. This is because settlements in March will need to be done from existing stockpiles (which may be relatively low), with no new corn coming into the market; while for the December settlement, there will be fresh planting, with the expectation of suitable weather conditions and/or increased area under cultivation, leading to lower prices.
Figure Source: The Handbook of Commodity Investing – Frank Fabozzi
Bull Futures Spread
In commodity futures contracts, near months react more quickly and by a larger quantum than farther months, in a bull market therefore, the prices of nearer month contracts will rise faster and further than a latter month contract. In such markets, a bull futures spread is a common strategy employed by traders. Here a trader would look to buy a nearer future contract and sell one further out, in the same market.
Heating Oil Contract Example of a Bull Spread
For example, assume a trader has the view that due to expected winter storms, the price of heating oil for January will be higher than the price of the forward May contract. The trader will then consider the advantages of buying Heating Oil January and selling the Heating Oil May contract.
Bear Futures Spread
Based again on the premise that nearer contracts react quicker and farther than later contracts, in a bear market price of nearer month contracts will fall faster and by a larger amount than those further out. In this scenario a bear futures spread strategy would be utilized by selling a nearer futures contract and buying one further out, in the same market.
Soybean Contract Example of a Bull Spread
For example, assume a trader has the view that an increase in supply of Soybean is expected to come into the market in September, putting pressure on the price of the upcoming month futures contract. The trader can then sell the Soybean September contract and buy the Soybean December contract to create the spread.
Futures Spreads and Seasonality
Many commodities tend to be cyclical, meaning there are expected periods in the year where the commodity is expected to trade higher, and times that the same commodity usually trades lower.
Let’s take grains as an example. When the crop is most vulnerable – i.e. when it is planted in the spring – the price tends to be higher than at the harvest time in the autumn. Similarly, commodities such as Heating Oil or Natural Gas are usually higher during the winter months due to higher demand. These seasonal changes are expected and usually priced in the future contract. Thus, a trader may employ a bull futures spread during a seasonal phase when prices are rising and may use a bear futures spread when prices are declining due to seasonality.
A trader can look to profit from this seasonality, both by trading an actual futures contract, or utilizing a futures spread trading strategy. However, unexpected weather conditions, such as a drought can affect the prices of grains and a warm winter, may drive the prices of heating oil lower than expected. In such conditions, trading the actual contract is riskier, not just because of higher margin requirements but also because the position is essentially unhedged, which may lead to higher losses and potential margin calls. Risks may therefore be better managed by trading a futures spread instead of an actual contract.
This is true for other events such as a threat of war, political upheaval or earthquakes. As in the seasonal examples, if the trader is in a futures spread, then both sides would be expected to rise or fall in a similar manner, leaving the spread position adequately hedged.
Understanding Spread Trading Margins
One of the biggest advantages of commodity futures spread trading is the lower margin requirements to enter and maintain a position. The price of a spread position is the difference in prices between the near-term contract and the latter contract, with the margin requirements being 5 to 10% of the contract price. For example, if March 2018 corn costs $700 a bushel and May 2018 costs $650 then the spread is priced at $50 with around $5 to $10 being the margin required, while the actual contract itself would have required a margin of anywhere between $30 to $70.
What is an Intercommodity Spread?
An intercommodity spread is another type of commodity futures spread in which the trader goes long on one commodity (on which he or she is bullish) and shorts another (on which he or she is bearish). The trader’s returns are then the difference in the prices of these two commodities. This type of a strategy would allow the trader to hedge their risks while reducing margin requirements at the same time.
Futures spread trading strategies are not hugely popular amongst retail traders. However, as we have seen above, they do have several advantages over trading the underlying/actual contracts and are amenable to both fundamental and technical analysis. They can also be very useful for traders with time constraints and smaller accounts.