In today’s volatile and sometimes uncertain markets, traders looking for a way to protect themselves should consider using spread trading. A spread is buying one futures contract and selling a related futures contract to profit from the change in the differential of the two contracts. Essentially, you assume the risk in the difference between two contract prices rather than the risk of an outright futures contract. There are different types of spreads and different methods for using each.
Pick your spread
Calendar spreads are done by simultaneously buying and selling two contracts for the same commodity or option with different delivery months. These spreads can be just the mechanical process of maintaining a long or short position through a roll period when the front month or spot contract goes off the board or putting on a position designed to benefit from a change in the differential. The further out you go in time, the more volatility you buy in the spread. CME Group offers calendar spread options in corn, wheat, soybeans, soybean oil and soybean meal (see “Knowing your options”). Calendar spreads are popular in the grain markets due to seasonality in planting and harvest. For example, for corn, in a July-Dec calendar spread, you are selling the old crop (July contract based mainly on carryover from the previous growing season) and buying the new crop (December contract based on the current growing season) (see “Out with the old, in with the new”).
Alternatively, you can execute a Dec-July spread, selling the new crop and buying the old crop. You also can trade a year- round spread, trading Dec-Dec. For wheat, you can do a spread trade for Dec-July, July-Dec, or July-July; and for soybeans July-Nov (old crop/new crop), Jan-May, Nov-July, and year-round Nov-Nov.
In an options calendar spread, you’re essentially buying time and selling the front month, or a net debit, explains Joe Burgoyne, director of institutional and retail marketing at the Options Industry Council. “The benefit of that is you have the time decay or the erosion working in your favor as the front month option that you’re short gets closer to expiration,” he says, adding that you should execute the strike where you anticipate the underlying being at expiration because the optimum value of the spread is when the future is at the short strike at expiration.
“[A calendar spread] is a long volatility spread. You are long volatility, so it makes sense for an investor to have some sense of where volatility levels are in those two options, especially the one you’re buying further out in time because that’s going to be a little bit more sensitive to volatility than the front month, which is more sensitive to the erosion aspect,” Burgoyne says.
In commodity markets, however, many of the fundamental assumptions of spread trading have been turned upside down by the emergence of long only commodity funds. These funds benchmarked to various commodity indexes maintain a long only bias and roll those positions at a predetermined time based on the index prospectus. The S&P GSCI (Goldman Sachs Commodity Index) rolls its positions on the fifth to ninth business day of the month preceding expiration.
Because funds benchmarked to these indexes have become so large -- positions in some agricultural commodities exceed the previous year’s total carryover -- the nature of certain spreads has changed. For instance, in bullish seasonal markets, front month contracts traditionally would outperform further out contracts but because of the size of the roll where huge volumes of the front month are being sold and long positions are being rolled to the next month, that has changed. There have been instances where what would be considered a “bull spread” (buying the front month and selling the further out contract) has lost money during a bull market because of the “Goldman roll.”
To combat this effect, many traders have entered “bear spreads” (selling the front month and buying the further out contract) prior to the indexes’ roll periods hoping to take advantage of money flows. This often has been effective, but presents a problem if a serious supply issue arises pushing the spot month contract higher. This happened in September 2006, costing bear spreading locals in the wheat pit at the Chicago Board of Trade in excess of $100 million by some estimates.
The bottom line is that some traditional relationships have changed and traders need to be aware of fund activity when entering spread positions.
For intermarket spreads, sometimes called inter-commodity spreads, you are buying and selling different but often related commodities, usually in the same expiration month. CME Group offers intercommodity Treasury and swap spreads between U.S. Treasury futures and between U.S. Treasury and CBOT Interest Rate Swap futures. They also offer an Intercommodity Spread Curve Tracker to track Treasury and swap spread levels.
“In intermarket spreads, you’re trading the changes in relationship. These changes tend to be mean-reverting. You can look at two markets and they will stay in some band referred to as the basis. When it’s in the upper end of the band, you trade expecting it to go to the middle of the band,” says Jeff Quinto, trading coach, electronicfuturestrader.com.
One example of an intermarket spread is a spread between hard red winter wheat traded at the Kansas City Board of Trade and soft red winter wheat traded at CME Group. Because Kansas City wheat is used for bread and export while Chicago wheat is used for cakes and pastries, market conditions will affect each differently, Quinto explains.
“[If] you think there’s going to be an increase in exports, you would want to buy the Kansas City and sell the Chicago. You’re first going to chart them and get a sense of the relationship between the two contracts. Then you’re going to try to see if one seems to be at a higher price relative to the other, or vice versa. You’ll set up a fundamental belief that exports are going to be increasing, which would tend to favor Kansas City. Then you’ll see if the chart relationship between the two would support that; whether the market has taken into consideration what you believe the fundamentals to be,” he says. You’ll then look at the chart to see if it makes sense to establish a position long Kansas City and short Chicago.
There are also unique spread strategies for certain commodities. You can trade the crack spread by buying heating oil and unleaded gasoline futures and selling crude oil futures. The crack spread represents the theoretical refining margin, according to the CME Group website. If a crack spread is positive, then the price of the refined products is higher than crude. If it is negative, the products are priced less than crude. The basic crack ratio is 3:2:1, which refers to three barrels of crude producing two barrels of unleaded gasoline and one barrel of heating oil. Unleaded gas and heating oil are priced in gallons, not barrels (42 gallons).
In a crush spread, you simultaneously trade soybean futures vs. their products, soybean oil or soybean meal.
“Basically you’re taking the products vs. the underlying commodity and trying to figure out the difference between that, the cost of the crush. When you do the crack spread [you’re figuring out] how much product you’re going to get out of a barrel of crude oil,” says Kevin Kerr, president of Kerr Trading. There’s a specific mathematical equation to figure out each, and CME Group’s website offers a calculator for the crack spread.
“Depending on what your outlook is on a particular market, you can design the spreads around that. You would just have to know the mathematical evaluation for the amount of crude vs. the different products and you can trade the spread based on that. It’s one of the most flexible things in the commodities markets, being able to do some of these spreads and design it to more of what you’re trying to accomplish,” Kerr says.
Tricks of the trade
Spread trading can be less risky than taking an outright futures position but not always, so you need to be careful. While generally, related markets will move in the same direction based on fundamental information with that information affecting one side of the spread more acutely, there are times when spreads can be as volatile as outrights. This occurred in our wheat example from 2006 and in markets that are subject to seasonal factors such as natural gas.
“Spreads can be more of a measured risk than outright trading. Volatility can be reduced because you’re really just playing the difference between two prices as opposed to an outright price,” Quinto says.
Burgoyne agrees. “Assuming we’re one for one in an option, [spreading is] a wonderful vehicle to hedge some of your risk. The debit you put out for the spread, the volatility component of a particular spread, those things are hedged somewhat when you get into a spread,” he says.
Another benefit to spreads is that they move slower than the outright market. “You have limited risk, so it’s good that it’s not going to move quickly,” Kerr says.
There are many common mistakes that those starting out in spread trading should avoid, however. One is not understanding what’s happening in the market. “[Some] take an overly simplistic view,” Quinto says. “My advice is to specialize in a limited number of spreads, maybe even one kind of spread that you try to learn and understand as much as possible.”
Burgoyne says traders should know the volatility involved in their option spreads. “You want to have some sense of where that instrument’s going to be at expiration. Because as it either blows through the strike or drops much further below the strike, the value of that spread contracts. Have some sense of the applied volatility of it because it is a spread that is long volatility. If after you buy the spread, the implied volatility starts to drop, the drop in that implied volatility may be a bigger loss than the erosion of the front month option that you’re short,” he says.
Quinto says traders should have a stop-loss point. “In spreading, this is a problem because it’s not simple to put in a stop-loss, you have to do it manually. You have to be disciplined to stop yourself out of the trade. People get lulled into the idea that it’s moving so slowly that they wait [too long] until it gets really bad. You need to have strict risk parameters. When you enter a trade, you need to decide how much you’re willing to give it and give it no more.”
Kerr says it’s smarter to trade the “ready-made” spread market on exchanges rather than attempt to “leg in,” especially when first starting out. “Legging in” refers to entering the individual sides of a spread independently. While on occasion you may be able to get your price or make an extra tick through legging, that all can be wiped out and then some if you are executed on one leg and not the other side and that runs away from you. By trading a spread market, “you’ll have a very clear-cut bid-ask market on the spread itself and not just on one leg of the spread and risk getting into a far different price than you anticipated.” He says traders should remember that transaction costs are double on spreads.
Kerr notes that if you do leg into the spread, you must execute the buy portion of it first. “You don’t want to be writing an option and trying to leg into the other side of it. It’s important to execute the spread in a certain way that you’re not going to have unlimited risk. The markets move fast.”