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Lesson 6: Spread Trading

Commodity, Spread Trading, commodity spread trading

Commodity, Spread Trading, commodity spread tradingWe have seen in the previous article how to invest in commodities, let's see now, the best way to trade commodities: the Spread Trading. Let me start immediately with the definition of the term Spread. The spread is the price or yield differential, between two financial instruments correlated to each other. 

Examples are the difference in price between two stocks belonging to the same sector (such as Goldman Sachs and JP Morgan both banking sector) or two indices (like S&P 500 and DJ30). But even as yield between German Bund and the American 10 years T-note.

In the commodity market, the spread is the price differential between two futures of the same commodity with a different delivery, or between two commodities correlated to each other.

What is, then, the Spread Trading? We make Spread Trading when we buy one or more future contracts and, simultaneously, we sell another or more future contracts, correlated to each other in order to have a balanced net position.

An example of spread trading is SBH18-SBK18 (buy sugar future delivery March 2018 and sell sugar future delivery May 2018). Spread that we build by subtracting from the price of the first future (sugar delivery March) the second one (sugar delivery May).

The two (or more) futures that make up a spread are called legs of the spread. We can decide to open the position at the same time, or with one leg at a time. It is possible to transform a trade with a future into one of Spread Trading and vice versa, depending on the time.

There are three types of Spread Trading.

Intramarket. When you are long and short futures in the same market but in different months. This type of spread is defined as Calendar Spread. An example of Intramarket spread is NGN18-NGU18 (buy natural gas future delivery July 2018 and sell natural gas future delivery September 2018).

Intermarket. It can be accomplished by going long futures in one market, and short futures of the same month in another market. Intermarket spreads can become Calendar Spreads by using futures in different months. An example of Intermarket spread is ZCK18-ZWH18 (buy corn future delivery May 2018 and sell wheat future delivery March 2018).

Inter-exchange. It is a less common method to create spreads, and it happens when we buy future contracts in similar markets, but on different commodity exchanges. In this case too, if the two legs have different deliveries it is called Calendar Spread. An example of an Inter-exchange spread is MWZ18-ZWK18 (buy wheat future delivery December 2018 at the Minneapolis Grain Exchange and sell the wheat future delivery May 2018 at the Chicago Board of Trade).

Spread Trading has significant advantages. First, we remove the directionality of the markets. We do not want more that a future rises or falls. The only thing that matters to us is the spread, that is, the difference between the two legs prices. If we buy corn and we sell wheat, we will earn if the corn rises and wheat drops, if both go up, but the corn more than wheat, and if both descend but the wheat more.

Spread Trading is not correlated to other financial markets and provides an excellent opportunity to diversify our portfolio, reducing the risk.

We have less risk than the simple futures. Entering in opposite directions on the market, in fact, we create a hedge of our position. Moreover, compared to the futures, spread trading reduces a lot the volatile, and we are protected by macroeconomic news or particular events.

Another quality of Spread Trading is the fact that we can make excellent gains even during phases of lateralisation of the legs. The spreads are much more often in trend, and this can last for a long time making it less stressful to trade.

More importantly,  when we are in a spread, we have no exit order in either market (long and short legs). Our trade is anonymous, nobody has an idea what our true position and intent are. No stop means no stop hunting and we are also more protected against intraday noise.

There is to say that in recent years the "strong hands", as a result of greater consideration of Spread Trading by small traders, a bit of stop hunting they do it, but still little compared to the futures market.

Spreads can be filtered through the seasonality, backwardation, and differential of the transport costs, in addition to the usual filters that are used in futures analysis. We will see better these aspects in the next chapter on fundamental analysis.

Spread Trading takes much less time; we are not forced to spend our days in front of a monitor watching the real-time quotes. Working on EOD data (End Of Day), it takes little time for organising the next day. So, it is ideal also for who makes trading like a second activity. In this way, we do not use real data that would give us a cost, with a further save of money.

Moreover, the low volatility of the Spreads is recognised by most brokers who apply a discount on the margin. Especially for Intermarket trades compared to the single futures. In this way, we can also work with small accounts.

After all these advantages, now the very few disadvantages. Spread Trading does not operate on a single future, but on a differential between two or more futures. So, we will have more commissions to pay. But nowadays, with online brokers with competitive low commissions, it is not a big issue and, however, they are insignificant when compared to all the advantages that the Spread Trading offers us.

I conclude by saying do not even think for a moment that the Spread Trading is easy. In trading, in practice, there is nothing of easy, including the spread trading. As we have seen, with the spread trading we have a lot of advantages but, at the same time, there are several aspects we have to take into account such as the weather, economic decisions, political situation of a nation, etc. You will see them in the next articles.

Seasonalgo, seasonal trading, spread trading, commodity market

 

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