While it requires a firm grasp of the complexities of the futures market, futures spread trading offers great rewards for those brave enough to utilize it. As such, it is often seen as the realm of the true professional and something every day trader should one day aspire to.
Common spread types: commodity futures
Inter-commodity futures: These futures involve contracts that are spread across various markets. As an example, if you believe that the wheat market is going to experience a high demand when compared to the corn market then you would buy wheat and sell corn. The specific prices for each don’t matter as long as wheat prices beat corn prices.
Calendar Intra-Commodity: This spread looks at a single commodity between differing months of the year. As an example, if you believe that the wheat market is going to be stronger in November as opposed to June then you would go long in November and short in June. The specifics of the price don’t matter as long as prices are higher in November than they are in June.
Bull futures: This spread looks at a single commodity under the assumption that the sooner month will boast a higher price than the later month. As an example, if you buy a bullish wheat future in May then you will want the price to be higher then, than when you sell it in June. For this type of future, it is important to keep in mind that near future contracts tend to move faster the further you get from the front month which gives this future its name. A bullish trader would then be one who buys in the front month in hope that it ends up moving at a greater rate than the deferred month.
Bear futures: This spread occurs if you purchase the same commodity in such a way that you are short in the front month and long on the deferred month. As an example, if you purchase wheat in May and sell it in June then you are hoping the prices are lower in May than they will be in June. For this type of future, it is important to keep in mind that near future contracts tend to move faster the further you get from the front month which gives this future its name. If you are confident that prices are at a low point then this is the type of spread you should consider buying into.
Futures spreads trading margins
It is important to keep in mind that if they are part of a spread then the individual margins on specific contracts are going to be reduced. As an example, if the margin on a specific wheat contract alone is $2,000, but if you go both long and short on wheat in the same year then the margin between the pair could be as little as $200. If you go both long and short on the same commodity in different years the margin will be roughly double, so in this case it would be about $400. The price differential occurs because the volatility of the spread is lower than that of the individual contract.
Essentially, the futures spread provides you with the ability to consider the market in slow motion. As such, if something serious happened in the wheat market then both contracts would be affected in the same way which provides a level of protection against the increased risk that the single contract doesn’t have.
Futures spread pricing
The price of a futures spread can be determined by the perceived difference in the two contracts. To determine what the spread’s pricing is going to be, all you need to do is subtract the deferred month price from the front month price. If the front month price is lower, the spread will be negative while if it is higher the spread will be positive. The tick values for both spreads and individual contracts are going to remain the same. As an example, if the price of wheat in June was $500 per bushel and in July it is $510 then the spread price is -$10. Meanwhile if the difference was $500 and $490 then the spread would be $10.
Types of markets
Contango markets: A market is considered Contango if the front month is obviously going to have a lower cost than the deferred month. Typically, this means the deferred month is going to cost slightly more than the front month due to cost to carry. The cost to carry takes into account the interest rate on the capital that is related to operating and owning the store that actually sells the commodity along with storage costs for keeping the commodity for the extra time along with additional insurance costs. This is considered the default type of market.
Backwardation markets: A market is thought to be in backwardation if the near months are valued highly when compared to the deferred months. Also known as an inverted market, it is the opposite of the standard market condition. It most commonly occurs if the market is in the midst of a bull phase which is often caused by an issue with the supply chain or a dramatic increase in demand coupled with a limited supply. The price differential occurs because the front months are going to feel the full brunt of the situation while it is more likely to be mitigated by the time the deferred months arrive. This is even more likely to be the case if the deferred month is in a different crop year from the front month.
Regardless of the current state of the market it is important to take seasonal concerns into account as well. Generally, gasoline prices are always going to be higher in the summer and the prices of heating oil, natural gas, and coffee are always going to be higher in the winter. Additionally, it is important to keep in mind that while all markets experience bullish and bearish periods, those experienced by the commodities are less consistent.