Spreading Basics - The Mechanics of Profitable Spread Trading - Bob McGovern
The concept of commodity futures spread trading appears simple. The trader enters a long position on one side of the spread, while simultaneously entering a short position on the other side or "leg" of the spread. The long and short sides can be in the same commodity, or they can be in two or occasionally three different commodities.
If the spread consists of commodity futures contracts of different months in the same commodity, it is called an intracommodity spread. An example would be Long December Wheat vs. Short July Wheat. If the long and short legs of a spread are in different commodity futures contracts, the spread is an intercommodity spread. Example: Long March Soybeans vs. Short March Wheat.
Everyone does fine up to this point. It is only when the words, "bull spread, bear spread, inter-crop, crush, reverse crush, carrying charge spreads and crack spread" are mentioned, when some confusion arises. Understanding these terms, besides the unique verbal protocol required to place spread orders, has kept many confident open position traders away from spreading.
Comprehending the activity on the floor once the spread order is entered is a definite requirement for the trader; for what he might consider a "bad fill " may in reality, have been a very good execution.
Consider a Long July Corn/Short July Wheat spread, entered "at the Market." The trader's screen may show a difference of $1.04 per bushel between the two commodities, and he may expect that difference to be his spread differential. However, the trader must understand that the trade has to be executed in two different trading pits, so the physical aspects of the trade execution must be realized.
It is possible that the actual spread trade could be made at $1.04, or even greater, but the trader can't assume that. The logistics of the trade are much simpler on intracommodity spreads, as they are made in the same pit.
The mechanics of the spread itself should be studied. To establish order in spreading, the "buy" or long position is always mentioned first, then the "sell" or short side of the spread is mentioned last. This protocol should be used when placing orders. Then, if the spread order is a limit order, the trader states the premium on the "buy" or "sell" side. An example: "I wish to place a spread order as follows, buy 3 April Live Hogs and Sell 3 October Live Hogs, plus 300 points (or $3.00) to the sell side." (What I am saying is that I want this spread, but October must be sold at least 300 points over the April, which I am buying).
So, let's assume this spread has filled, with the October Live Hogs sold at $42.60 per hundred, and the April Live Hogs bought at $39.60 per hundred. I didn't care what the individual prices were; October could have been sold at $90.00 per hundred, just as long as the differential between that contract and the April contract was $3. If the October were at 90, then the April would have been at 87.
Now, what next? My reasoning for making the trade was that I felt the difference between the two contracts was too great, and a seasonal tendency to narrow existed. Therefore, I want to see that difference narrow. I don't have to figure how much my short October is making or losing, or calculate how much the long April contract is making or losing. All I have to check is the difference in price between the two contracts. If it's less than 300 points, I have a profit; if it's more than 300 points, I'm losing.
Let's assume the spread has narrowed to 200 points, October over April. I decide to take the profit, which is 100 points ($400) per spread, before commissions. I don't want to enter a market order, so I place the following: "On a spread, Buy 3 October Live Hogs (I am covering my short) and Sell 3 April Live Hogs (I am closing out my long); plus 200 to the Buy side." Say I "luck out" and get a better fill. Would it be a differential less than 200 points, or more?
The Long April /Short October Live Hog spread happened to be a "bull spread," which meant that the nearby month was expected to be the stronger price performer than the October. The spread was also an intracommodity spread; both sides of the spread were Live Hogs. The spread was also a "seasonal" spread. I'll cover more on Seasonals, carrying charge spreads, crush spreads, etc., at a later date.
Spreads normally have less margin requirements than open positions, and in the Live Hog spread above, current initial margin requirement is $164 per spread. The initial margin requirement for an open position either long or short is presently $540.
Another point to consider in spreading, besides lower margin, is the multiplicity of ways a profit can be made in a spread, as opposed to an open position trade. Here are some factors to consider:
There is only one way to profit on an open long position; it must go up in price. There is only one way to profit from an open short position; it must go down.
‚ To profit on a spread position, the long side can go up, while the short side stays the same; the short side can go down while the long side stays the same; the long side can go up and the short side can go down (most ideal); the long side can go up more than the short side is going up; the short side can go down more than the long side is going down.
Let me reiterate again; I don't care where the individual prices are, I only care about the relationship between the two.
Here's another spread situation with a different twist: Buy July Coffee and Sell March Coffee, plus 200 points to the Buy side. Say the order fills with the July Coffee bought at $1.7000 per pound and the March Coffee sold at $1.6800 per pound. Is this a bull spread or a bear spread? Do we want the spread to narrow or widen to make a profit? How would we word an order to close this spread out?
Any other reasons for entering spreads? Well, for the most part, there are certain seasonal factors which ultimately have influence over commodities. Most spreads are based on these age-old seasonal influences. Examples include harvest pressure in June-July on Wheat; in Oct-Nov on Soybeans; and Corn harvests in early fall. All these influences set up new-crop/old-crop spread situations; intercommodity spreads such as Wheat/Corn, etc.
I'll cover more aspects of spreading in a future letter (no pun intended). To me, they have been a fascinating avenue for trading?
(Bob McGovern is the author of "Commodities Futures Spreads" a biweekly newsletter. He is also CEO of R. B. McGovern & Associates, Member NA, NASD, MSRB, SIPC, and is a Registered NA Introducing Broker, CPO, and CTA).
Editors Note: I have dealt with Bob and he is extremely knowledgeable, experienced and helpful.
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