by Don Wellenreiter
There are three basic types of spreads: the intra-market, the inter-commodity, and the inter-market spread. The intra-market spread, also known as an inter-delivery spread, is by far the most common spread. When using this type of spread, the trader would be buying one month and selling another month in the same commodity. An example of this would be buying October cattle and selling December cattle.
The inter-commodity spread consists of buying one commodity and selling a related commodity. Traders use this type of spread when they feel that there is a disparity between the two commodities. An example of this would be if traders felt the price of corn was too low as compared to oats. To take advantage of this possible disparity they would buy corn and sell the oats.
The third type of spread is the inter-market spread. This is a spread that involves buying a commodity on one exchange and selling one on another. Examples of this type of spread would be buying the Kansas City Value Line Index and selling the S&P 500 on the Chicago Mercantile Exchange. The trader in this case is betting that small cap stocks (which dominate the Value Line Index) will outperform the large cap stocks in the S&P. This trade is very popular in the November/December period as traders attempt to play the “January Effect”. The next example deals with the difference in transportation, deliverable grades, distribution of supply relative to location, and historical and seasonal basis relationships. Buying Chicago September wheat and selling Kansas City September wheat or the July Minneapolis/Chicago wheat spread, are examples of this type of spread. Because of the numerous differences that must be known before putting on these types of trades, a trader must be prepared to do a lot of homework first.
Within the above mentioned types of spreads are the sub-categories of spreads. The majority are either bull spreads or bear spreads. As you can imagine, their titles indicate the direction the trader would like the spread to head in. An example of a bull spread would be when a trader believed that orange juice was going higher relative to the back months. He could then purchase the September contract and sell the January. When you are long the nearby futures and short he further out futures, this is considered a bull spread. Conversely, if in February the trader believed that heating oil had made its seasonal highs, he could buy the July contract while selling the March. He would then have on a bearish spread, as he is short the nearby and long the further out contract.
Another type of spread is the limited risk spread. We have already used this type of spread in the previous example of December wheat vs March wheat. While this is basically an intra-market spread, there is a difference. It only applies to storable commodities. Storable commodities, for the most part, include soybeans and their products, corn, wheat, oats, copper, cotton, orange juice, cocoa, and pork bellies. Live cattle would be an example of a non-storable commodity. If the commodity you are trading is one of the storable types then they can be considered a limited risk trade. What this refers to is that the maximum premium that a more distant or back month can command over a nearby contract is approximately equal to the cost of taking delivery, holding the commodity for the length of time between the two expirations, and then redelivering. In our wheat example, the cost of carry was -21 cents. Anything near 70% of carry is considered full carry, so, in our example, whenever December wheat traded at a 15 cent discount to March it would be considered at full carry. Always keep in mind that, although a spread may be at or near its cost of carry, it does not mean that it cannot trade below that level. Variables such as interest rates, insurance, and storage costs can greatly change the cost of carry and increase the trader’s total risk.