Learn the basics of trading spreads, which can conserve capital and provide a steady way to participate in the markets. Learn about everything from intermarket and intercommodity spreads to intracrop spreads. It’s all here! This method is perfect for traders who like to minimize risk and appreciate the slow and steady approach.
What is 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. Let’s say you bought a July wheat contract at $4.75 per bushel while selling a December wheat contract at $5.25 per bushel. The spread between them would be -50 or 50 cents to the December contract. If the value of July gains by 10 cents, your gain would be $500 in profit. In this case the spread would narrow. If the value of July loses 10 cents, your result would be a $500 loss. This would mean the spread widens.
One of the most common spreads is the intramarket spread. This is the buying and selling of two different delivery months in the same market. Let’s say you are buying one July wheat contract and selling one December wheat contract. If the July wheat increases in value relative to the December wheat, the position will show a gain because you are long July. Another outcome would be if July wheat decreases in value relative to the December contract, then this position will result in a loss.
The wheat market provides the most popular intermarket spreads because three different wheat contracts represent three different varieties of the crop—all of which are grown in different parts of the country. You can choose to spread soft red winter wheat at the CBOT, hard red winter wheat at the Kansas City Board of Trade or hard red spring wheat at the Minneapolis Exchange.
Another type of spread is an intercrop spread. This is a spread that reflects the underlying fundamentals of two different crop years (i.e. July/December corn or July/November soybeans). There is also an intermarket spread is a spread that reflects a different variety of a commodity (i.e. December Chicago wheat and December Kansas City wheat). The intercommodity spread is another type which involves trading two different, yet related markets (i.e. corn and wheat, or gold and platinum).
In an intercommodity spread, you trade two different, but related markets. Be aware that only a few of the combinations of intercommodity spreads are exchange recognized and receive reduced spread margin requirements. If the markets are not somewhat related, then you are taking two outright positions, not a single spread position.
Margin requirements reflect the risk and volatility in the underlying market or market relationship. Although spreads typically exhibit less volatility and less risk than an outright futures position, it is possible for any spread to have a higher margin requirement than the sum of its components. Please check with your RJO Futures broker before placing a spread trade so you are up-to-date with current margin requirements.
To Spread or Not to Spread?
As you know, spreads usually are less volatile than outright futures positions. For many spread traders, that is a good thing. They are not pursuing sudden, oversized sudden gains, but simply a slow, steady way to participate in the market. Indeed, with a spread, you may be able to withstand an extreme market movement that would have forced you out of the market with an outright trade. Trading spreads also is a good way to either conserve the percentage of account funds devoted to margin requirements or diversify your positions across more markets. In either case, you could be risking a smaller portion of your account on any one position.
Spread trading has many benefits, as well as some drawbacks. Because spread trading is off the beaten path for most traders, it may be an excellent arena if you are willing to study and practically implement your knowledge about how prices related to one another, with less competition.
For more information on spread trading, check out our Spread Trading Explained video featuring Senior Market Strategist, Phillip Streible.”