THE UNDAMENTALS AND ECHNIQUES RADING OMMODITY PREADS. c s

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1 c s THE UNDAMENTALS AND ECHNIQUES OF RADING OMMODITY PREADS

2 The purpose of this booklet is to give you a better understanding of various aspects of spread trading in the futures market. Center for Futures Education, Inc. PO. Box 309 Grove City, PA (724) FAX: (724) e- mail: info@thectr.com ISBN Copyright Center for Futures Education, Inc. All rights reserved. No portion of this booklet may be reproduced without permission from the Center, except by a reviewer, who may quote brief passages in a review.

3 TABLE OF CONTENTS History 1 What is A Spread? 1 Risk and Margin Requirements 2 Types of Spreads 3 Limited Risk or Low Risk Spreads 4 High Risk Spreads 5 Calculating Profit Potential 5 Tax Spreads 5 Analysis of Spreads 6 Charts 7 Orders 11 Glossary 12 Commodity Transaction Record 15

4 HISTORY For many years, spread trading was used primarily by the professional and commercial traders. The lack of knowledge among brokers and speculators, plus the complexity in placing orders, made this type of trading limited to those few with the necessary expertise. Even with the growth of the futures industry in recent years and the advancement of education to the public, spread trading still ranks as one of the least known facets of futures trading. WHAT IS A SPREAD? A spread or straddle is the simultaneous establishment of a long position in one futures contract against a short position in the same or a related futures contract. There is sometimes a confusion in the words spread and straddle, but for the purpose of this booklet, the two words will be used synonymously. Traders who establish a spread position are not primarily concerned with upward or downward price movements, but rather the change in the difference between the prices of the two futures contracts. An example of a spread transaction is as follows: January 15 Bought 1 March and simultaneously Sold 1 June January 20 Sold 1 March Gold a and simultaneously bought 1 June The results of this total transaction showed a $ profit on the March Gold and a $50.00 loss on the June Gold or a net gain of $50.00, less the commission charge on the spread. The original spread of January 15 had a 200 point difference between the March and June Gold, but by January 20 this difference had narrowed to 150 points, resulting in the 50 point, or $50.00, profit. January 15 Bought 1 March Gold January 15 Sold 1 June Gold Difference 2.00 = 200 points 1

5 January 20 Sold 1 March Gold January 20 Bought 1 June Gold Difference 1.50 =150 points Narrowing of Difference +50 points If the spread had widened to 250 points, it would have resulted in a loss of $50.00 before commissions. Again, the profit or loss on the spread transaction was determined by the change in the price difference between the two contracts, not by their individual upward or downward movement. There must be an economic relationship between the two sides of a spread, as evidenced by a similar price movement. For example, buying copper and selling sugar is not considered a spread because there is no economic relationship between the two commodities. RISK AND MARGIN REQUIREMENTS The speculator trading spreads must realize that the risk can be as great for him as for the net long or short trader. When you trade spreads, you must plan and measure the risk factors involved in the spread. Some spreads may afford less risks than outright positions, such as the carrying charge (limited risk) spread. Other spreads, such as those in nonstorable commodities such as cattle and hogs may afford more risk at times than outright positions because each side of the spread could fluctuate independently and diverge, causing a larger loss than either position would have experienced separately. Margins on spreads are normally lower than those on outright positions, giving the trader greater leverage on his invested capital. If a trader removes one side of a spread (also referred to as lifting a leg), he now has an outright long or short position and is no longer entitled to the spread margin. The amount of margin required for different spreads is determined by each brokerage firm, with a minimum established by each exchange. 2

6 TYPES OF SPREADS There are four basic types of spreads. 1) Intra-Market or Intra-Delivery Spread Simultaneously establish a long position in one month against a short position in another month or the same commodity on the same exchange. Example: Buy May Corn and Sell July Corn on the Chicago Board of Trade. 2) Inter-Market Spread Simultaneously establish a long position on one exchange against a short position on another exchange in the same commodity deliverable in the same month. Example: Buy May Wheat (Chicago Board of Trade) and Sell May Wheat (Kansas City Board of Trade.) 3) Inter-Commodity Spread Simultaneously establish a long position in one commodity against a short position in another commodity in the same delivery month. The two commodities must be economically related. Example: Buy May Oats and Sell May Corn. When trading this type of spread, an important factor to remember is that contract specifications may differ. 4) Commodity-Product Spread Simultaneously establish a long position in one commodity against a short position in any equivalent amount of the products derived from it. 3

7 Example: Buy Soybeans and Sell Soybean Oil and Soybean Meal. Spreads between soybeans and its products are known as crush and reverse crush spreads. This type of spread is usually for the sophisticated trader in the soybean market. Spreads between crude oil and its products (heating oil and gasoline) are known as crack and inverted crack spreads. LIMITED RISK OR LOW RISK SPREADS Falling under the category of Intra-Market or Intra-Delivery spreads is the limited risk or low risk spread. The trader involved in this type of spread buys the nearer month and sells the more distant month at a premium. Example: Buy 1 June and Sell 1 December The premium in this example is 400 points or $ December over June. The larger the premium in the distant month, the closer the premium is to full carrying charges. Carrying charges are defined as the cost of storage, interest, and insurance on the physical commodity over a period of time. Only storable commodities, having carrying charges, can be used in a limited risk spread. The trader profits only if the spread difference narrows (strengthens). To determine whether the spread strengthened or weakened, make the following calculation at the starting of the spread position and at the close: Near month price - Deferred month Price = Spread For most commodities, the spread is normally a negative number. A strengthening spread occurs as the spread becomes less negative (or more positive). A weakening spread occurs when the spread becomes more negative (or less positive). A strengthening spread is profitable for a trader with a limited risk spread. 4

8 HIGH RISK SPREADS When the far month is selling at a discount to the near month, this is called an inverted market. In this case, the trader would profit if the difference between the months would continue to widen (weaken), so he would buy the near month and sell the distant month. Example: Simultaneously Buy December Corn at 3.06 and Sell March Corn at This type of spread should always be discussed with your account executive at your brokerage firm before initiating, since there can be unlimited losses. CALCULATING PROFIT POTENTIAL To determine profitable spreading opportunities, calculate the spread: Nearby - Deferred = Spread Next, divide the spread by the number of months covered by the spread; e.g., March to May is 2 months, March to July is 4 months: Spread / # months = Per Month Spread When comparing spreading opportunities, compare the per month spreads. For low risk spreads (bull spreads), look for the most negative per month spread. For high risk (bear) spreads, look for the most positive per month spread. These provide the most profit potential. TAX SPREADS The law requires that, at year end, a taxpayer determine his unrealized gain or loss in all commodity futures contracts traded on U.S. exchanges, which are referred to as Regulated Futures Contracts. Technically, this is called marking-to-market. The net unrealized gains (or losses) would be treated as if they were 60 per cent long-term and 40 per cent short-term; however, capital gains are taxed at the same rates as ordinary income, so no advantage comes of this distinction. Special Note: The above provision does not apply to hedging transactions. For further information about taxation of spreads, see Tax Treatment of Commodity Futures and Futures Options (Center for Futures Education, Inc., Grove City, PA 16127, 1999). 5

9 ANALYSIS OF SPREADS Each spread is different, and should be analyzed on an individual basis. The following are factors to take into consideration. HISTORICAL INFORMATION The trader should review the historical relationship of spreads in the past year in comparison to the present day. He should note any similarities between the years. Support and resistance levels at certain price differences may be seen, and also look for volatility distorting price relationships. SEASONAL PATTERNS Seasonal price patterns are important to spread price relationships. They have a tendency to change, registering lows and highs at certain times of the year. These patterns are more applicable to certain times of the year, and to certain commodities than to others. Seasonal patterns can be distorted at times due to weather, variations in the time of harvest, and different actions by producers. Seasonal highs and lows in the futures market do not necessarily coincide with the spot price, since cash price highs and lows may precede or occur later than futures. TECHNICAL ANALYSIS Technical considerations in the form of chart analysis show the past behavior of spreads, in particular, where there are support and resistance areas. In analyzing charts, you should definitely take into consideration seasonal and historical factors, which may motivate changes in the trend. Charts often give traders a better idea as to the relationships of the spread prices. Several spread charts are shown on the following pages. 6

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12 FUNDAMENTAL ANALYSIS You should study the fundamental considerations that affect both the nearby and distant contracts. The same type of research should be used as that used when evaluating a net long or short position. Supply and demand can definitely affect the narrowing (strengthening) or widening (weakening) of the spread. Government reports as to supply and demand should be studied and interpreted because spreads can be distorted by such reports. In certain spreads, where one side is involved in a spot month that is soon to expire, the trader may find this side of the spread moving independently. The reason for this is that an expiring position may be dependent upon technical factors involving delivery. Also, in certain commodities, price limits are removed when entering the spot month. Thus, there is no limit in the upward or downward movement during a trading day. The trader must remember that a spread ends at the expiration of the nearby month. Different actions by the government can completely distort the normal spread. This could be in the form of export controls, price controls, or the anticipation of some type of government intervention. The trader must therefore be constantly aware of such influences. ORDERS Spreads should be entered and liquidated as spreads. Do not enter or liquidate one side at a time; this could result in increased commissions, and the possibility of poor executions. The two basic types of orders used for spreads are: (1)The market order-example: Buy 5 May Soybeans at the market and Sell 5 July Soybeans at the market. (2)The limit or price order specifying the amount of difference between the two contracts of the spread. Example: Buy 5 May Soybeans and sell 5 July Soybeans 20 premium July. Never enter a spread order at definite prices (such as Buy 5 May Soybeans at 7.71 and sell 5 July Soybeans at 7.92) because these two contracts may never be at those prices at the same time. The quote for a spread differential cannot be determined by using the prices of the two contracts, but is a separate quote received directly from the exchange floor. 11

13 GLOSSARY ACTUALS The physical commodities on hand, ready for shipping, storage, or manufacturers, as distinguished from futures contracts. APPROVED DELIVERY FACILITY Any stockyard, mill, store, warehouse, plant or elevator that is authorized by the Exchange for delivery of Exchange contracts. AT THE MARKET Orders entered to buy or sell At the Market are executed immediately by the floor broker at the best obtainable price. BEAR SPREAD Sell the nearby month and buy the distant month. BID An offer to buy a specified quantity of a commodity that is subject to immediate acceptance. BROKER A registered representative; either an account executive or floor broker who is given the responsibility for the acceptance and/or execution of an order. BULL SPREAD Buy the nearby month and sell the distant month. CARRYING CHARGE The cost to store and insure a physical commodity over a period of time. Also, involves interest charges and other incidental costs involved in ownership. C.F.T.C. The Commodity Futures Trading Commission. CLEARING The process of matching Buy and Sell orders which have been executed during the day, and making monetary adjustments to traders accounts. CLEARINGHOUSE A department or agency of the Exchange through which all trades on the Exchange are cleared and adjusted. CLOSE A period of time at the end of trading sessions during which all orders are filled within the closing range. 12

14 COMMISSION The fee paid for buying and selling commodities in a futures or cash market. CONTRACT MONTH The month in which a futures contract may be satisfied by making or accepting delivery. DAY ORDER An order that expires on the close of trading if not filled during that day. DELIVERY The tender and receipt of the physical commodity or the warehouse receipt in settlement of a futures contract. FIRST NOTICE DAY The first day on which notices of intention to deliver actual commodities against futures contracts can be made. FLOOR TRADER An exchange member who fills orders for his own account by being personally present on the floor. Usually called a local. FUTURES A term used to designate all contracts covering the sale of commodities for future delivery on a Commodity Exchange. LAST TRADING DAY This is the final day on which trading may occur or a particular delivery month. After the last trading day, any remaining commitment must be settled by delivery. LIMIT The allowable price movement for a given commodity during one day of trading. MARGIN The money or collateral posted with a broker or the clearing house to guarantee the fulfillment of a futures contract. MARGIN CALL A demand by the brokerage firm or clearinghouse for additional funds because of adverse price movement. NEARBYS The nearest active trading month of a commodity futures market. OFFER An indication of a willingness to sell at a certain price, as opposed to a bid. OPEN A brief period of time at the start of trading, during which all orders are executed within the opening range. 13

15 OPEN INTEREST The total number of futures contracts entered into during a specified period of time that have not been liquidated either by offsetting futures transactions or by actual delivery. P AND S A purchase and sales statement sent by a broker to his client showing both the purchase and sale of a contract that has been closed out. POSITION An interest in the market; an open commitment, either long or short. RANGE The difference between the high and low price of a futures contract during any given period. SETTLEMENT PRICE The price at which the clearinghouse clears all transactions at the close of the day. SPOT PRICE The price quoted for the actual, or cash, commodity. VOLUME The number of purchases and sales of a commodity made during a specified period of time. 14

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17 This concludes this booklet on the fundamentals and techniques of trading commodity spreads in the futures market. We hope that we have given you some insight on how to be an intelligent trader. The information and opinions expressed in this booklet do not constitute a solicitation for the purchase or sale of commodities. The information has been compiled from sources considered reliable; however, there is no warranty or representation expressed or implied as to the accuracy or completeness of the material herein.