Learn how spread trading can be another tool in your futures trading plan. In this article, we’re going to be discussing how to put on a spread trade, and the different types of spread trades that are available. We’ll also be discussing some of the risks involved in spread trading, as well as some of the reasons why people trade spreads in the first place.
The Basics of Spread Trading
Looking at spread trading, the reason why someone trade spreads, or how they do it, is that they simultaneously take opposite positions in the same or related markets. Looking at some of the basics, a spread trader always wants the long side of a spread to increase in value relative to the short side. This means that the spread trader wants a difference between the spread to become more positive over time.
Inch Spread or Market Spread
Now, some common spreads that people put on here is an inch, or market, spread. This is probably one of the most common ones that I execute for customers. It would be buying and selling two different delivery months in the same market. An example of this is buying the July wheat and selling the December wheat. If the July wheat increases in value relative to the December wheat, the position will show a gain because you are on July. Or, if the July decreases in value to the December contract, then this position would result in a loss. Now, quoting a spread and also looking at an example, whenever a spread trade is quoted, it’s always a single price. Never the two individual ones. And the way you get that is by subtracting the back month from the front month. Looking at a quick example, if you bought July wheat at 475 a bushel while selling the December wheat at 525 a bushel, the spread between that would be negative 50, or 50 cents to the December. If the value of July gains by ten cents, meaning the July rises from 475 to 485 while December remains at 525, your gain would be five hundred dollars profit. So the spread head narrowed. If the value of July loses ten cents, meaning July decreases to 465 while the summer remains at 525, your result would be a five-hundred-dollar loss, meaning the spread would widen. Also it’s important to remember that the December contract would most likely be moving also. In in this generic example I cut the December contract fix, but in most scenarios you would see December move up and down as well in relation to the July contract. So it’s possible for July to move up and December to move up also, or any combination of that.
Different types of spreads, an intramarket spread. The position attempts to take advantage of the price difference between two delivery months of a single futures market. A popular intramarket spread is the December-May corn, or the April-June cattle. This will look at this this crop that’s being planted versus when the crop is being harvested.
Also an intercrop spread. It’s a spread that reflects the underlying fundamentals of two different crop years. So oftentimes it could be a crop that’s in storage like the July corn, versus the December corn, which would be being harvested. Or the July beans versus the November soybeans.
Another type of spread is the intermarket spread. It’s a spread that reflects a different variety of a commodity. The most popular one is the December Chicago wheat versus the December Kansas City wheat, or the Minneapolis wheat versus the Chicago wheat, or Minneapolis vs. Kansas City. A whole number of different contracts that are all of the same type of product. Someone might look at the West Texas crude versus a crude oil that’s based out of Oklahoma, or another one of the delivery points.
When looking at an intercommodity spread, it’s trading two different, yet related, markets. So popular intercommodity spreads would be corn versus wheat, corn versus beans, gold versus platinum, gold versus silver, oil versus unleaded gas, or oil versus heating oil. So a number of different ones, but they’re yet related. They might be some kind of byproduct of another product.
Now remember that futures and options trading does involve risk of loss, if you have any questions give us a call here at RJO Futures. Good luck, and good trading!
Want more information on spread trading? Download our Introduction to Spread Trading guide for an in depth look at this trading approach.