Lecture 5
Spread Trading
Primary Texts
Edwards and Ma: Chapter 4
CME: Chapter 7
Spreads
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In addition to outright long and short positions, traders in futures
markets commonly trade spreads.
The price difference between two futures contracts is called the
spread.
For example, the July-September spread in wheat refers to the
difference between July and September wheat futures prices.
In general, an n-month price spread at a given time is defined as
FPt, T+n − FPt T = Spreadt,(T+n, T)
Trading spreads is based on the expectation that the spread (i.e.,
the price difference) may vary over time.
Spreads: An Example
Wheat Futures Contracts: Settlement prices and nearmonth spreads
Settlement
Settlement
Con. Month
2-Feb-13
Spread
Mar
563.75
May
576.75
13.00
Jul
588.75
Sep
Dec
26-Feb-13
Change in
Spread
Spread
521.50
11.00
-2.00
12.00
533.25
11.75
-0.25
612.75
24.00
558.25
25.00
1.00
633.00
20.25
579.75
21.50
1.25
510.50
Spread Trading
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Traders initiate spread positions when they think that the price
difference between the two contracts will change to their benefit
before the trade is offset.
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A spread position is initiated by the simultaneous purchase and sale of
futures contracts on
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In fact, traders do not care about the absolute prices of the contracts but
only the price relationship.
the same commodity but with different delivery months, or
different commodities with the same delivery month, or
different commodities with different delivery months.
Since spreads involves holding both long and short positions, price
changes in the underlying contracts generally result in simultaneous
gains and losses in both sides (or legs) of the spread.
Spread Trading
Why Trade Spreads?
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Spread positions are much less volatile than outright long or
short positions
Because of lower volatility, spread positions are considered to
be less risky than taking an outright position in the market.
Also, because of lower volatility, futures exchanges allow
traders to post a smaller margin on such positions.
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The initial and maintenance margins for outright long or short CBT 2013
Corn futures contract are $2,700 and $2,000, respectively.
The initial and maintenance margins for CBT 2013 Corn futures spreads
are $540 and $400, respectively.
Thus, trading spread is often viewed as a more conservative
speculation strategy
Spread Trading
Spread Trading Principals
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Taking a spread position is less risky than taking an outright
position in the market. However, it is possible to lose on each
side of a spread trade. In order to avoid such loss, the trader
must consider three issues:
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Choosing the contracts to spread – look at historical prices and
identify whether there is any systematic relationship between the
price series.
Know what the typical price relationship is, identify any
potential abnormal change in prices and spread, and forecast
correctly.
Choose the appropriate timing of initiating and closing the
spread position.
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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A spread between different contract months in the same commodity is
called an intra-commodity (or inter-delivery) spread.
Traders initiate intra-commodity spread position by simultaneous
purchase and sale of the same contracts but with different delivery
months.
Example: On 02 February 2013
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Jul. wheat futures price was 588.75 cents/bushel
Sep. wheat futures price was 612.75 cents/bushel
The Jul-Sep wheat spread was 24 cent/bushel.
Case 1: A trader expects that wheat futures prices will fall and the Jul.
wheat futures price will fall faster than the Sep. wheat futures price
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Spreading Strategy: On 02 February 2013 the trader will
Long Sep. Wheat futures & Short Jul. Wheat Futures
Spread Trading
Intra-Commodity Spreads: Trading Strategy
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Case 1: Futures Prices are Falling and the Spread is Expanding
Buy the contract the price of which is falling slower and sell the
contract the price of which is falling faster
640
Buy
620
600
580
Sell
560
540
520
500
480
460
1
2
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Example (continued): On 27 February 2013
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Jul. wheat futures price was 533.25 cents/bushel
Sep. wheat futures price was 558.25 cents/bushel
The Jul-Sep wheat spread was 25 cent/bushel.
If the trader closed her spread position on 26 Feb. 2013, her net
gain from the spread trading would be 1 cent per bushel
Spread Trade-1
Spread Trade-2
2-Feb-13 Buy 1
Sell 1
26-Feb-13 Sell 1
Buy 1
Results
Spread
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Example (continued): On 27 February 2010
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Jul. wheat futures price was 533.25 cents/bushel
Sep. wheat futures price was 558.25 cents/bushel
The Jul-Sep wheat spread was 25 cent/bushel.
If the trader closed her spread position on 27 Feb. 2010, her net
gain from the spread trading would be 1 cent per bushel
Spread Trade-1
Spread Trade-2
Spread
2-Feb-10 Buy 1 September wheat contract at 612.75 Sell 1 July wheat contract at 588.75
24.00
27-Feb-10 Sell 1 September wheat contract at 558.25 Buy 1 July wheat contract at 533.25
25.00
Results
-54.50
55.50
1.00
Spread Trading
Intra-Commodity Spreads: Trading Strategy
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Case 2: Futures Prices are Falling but the Spread is Shrinking
Buy the contract the price of which is falling slower and sell the
contract the price of which is falling faster
620
Sell
600
Buy
580
560
540
520
1
2
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Example: A trader expects that wheat futures prices will fall and the
Sep. wheat futures price will fall faster than the Jul. wheat futures price
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Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut.
On 26 February 2013: Jul. wheat futures price was 533.25 cents/bushel
Sep. wheat futures price was 548.25 cents/bushel
The Jul-Sep wheat spread was 15 cent/bushel.
Spread Trade-1
Spread Trade-2
2-Feb-13 Buy 1
Sell 1
26-Feb-13 Sell 1
Buy 1
Results
Spread
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Example: A trader expects that wheat futures prices will fall and the Sep.
wheat futures price will fall faster than the Jul. wheat futures price
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Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut.
On 26 February 2013: Jul. wheat futures price was 533.25 cents/bushel
Sep. wheat futures price was 548.25 cents/bushel
The Jul-Sep wheat spread was 15 cent/bushel.
Spread Trade-1
Spread Trade-2
Spread
2-Feb-13
Buy 1 Jul.wheat contract at 588.75
Sell 1 Sep wheat contract at 612.75
24.00
26-Feb-13
Sell 1 Jul wheat contract at 533.25
Buy 1 Sep wheat contract at 548.25
15.00
-55.50
64.50
9.00
Results
Spread Trading
Intra-Commodity Spreads: Trading Strategy
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Case 3: Futures Prices are Rising and the Spread is Expanding
Buy the contract the price of which is rising faster and sell the
contract the price of which is rising slower
14.8
14.4
14
13.6
Buy
13.2
Sell
12.8
1
2
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Example: On 02 February 2013
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Jul. sugar futures price was 13.16 cents/lbs
Oct. sugar futures price was 13.50 cents/lbs
The Jul-Oct sugar spread was 34 cent/lbs
Case 3: A trader expects that sugar futures prices will rise and the
Oct. futures price will rise faster than the July. futures price
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Spreading Strategy: Long Oct. Sugar Fut. & Short Jul. Sugar Fut.
Spread Trade-1
Spread Trade-2
2-Feb-13 Buy 1
Sell 1
26-Feb-13 Sell 1
Buy 1
Results
Spread
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Example: On 27 February 2013
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Jul. sugar futures price was 13.87 cents/lbs
Oct. sugar futures price was 14.22 cents/lbs
The Jul-Oct sugar spread was 34 cent/lbs
Case 3: A trader expects that sugar futures prices will rise and the
Oct. futures price will rise faster than the July. futures price
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Spreading Strategy: Long Oct. Sugar Fut. & Short Jul. Sugar Fut.
Spread Trade-1
Spread Trade-2
2-Feb-13
Buy 1 Oct sugar contract at 13.50
Sell 1 July sugar contract at 13.16
0.34
26-Feb-13
Sell 1 Oct sugar contract at 14.22
Buy 1 July sugarcontract at 13.87
0.35
0.72
-0.71
0.01
Results
Spread
Spread Trading
Intra-Commodity Spreads: Trading Strategy
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Case 4: Futures Prices are Rising but the Spread is Shrinking
Buy the contract the price of which is rising faster and sell the
contract the price of which is rising slower
14.4
14
13.6
13.2
Sell
Buy
12.8
1
2
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Case 4 Example: A trader expects that sugar futures prices will rise
and the Jul. futures price will rise faster than the Oct. futures price
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Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut.
On 26 February 2013: Jul. Sugar futures price was 13.87 cents/lbs
Oct. Sugar futures price was 14.15 cents/lbs
The Jul-Oct wheat spread was 28 cent/lbs
Spread Trade-1
Spread Trade-2
2-Feb-13 Buy 1
Sell 1
26-Feb-13 Sell 1
Buy 1
Results
Spread
Spread Trading
Intra-Commodity (Inter-delivery) Spreads
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Case 4 Example: A trader expects that sugar futures prices will rise
and the Jul. futures price will rise faster than the Oct. futures price
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Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut.
On 26 February 2013: Jul. Sugar futures price was 13.87 cents/lbs
Oct. Sugar futures price was 14.15 cents/lbs
The Jul-Oct wheat spread was 28 cent/lbs
Long Position
Short Position
2-Feb-13
Buy 1 Jul Sugar contract at 13.16
Sell 1 Oct Sugar contract at 13.50
0.34
26-Feb-13
Sell 1 Jul Sugarcontract at 13.87
Buy 1 Oct Sugar contract at 14.15
0.28
0.71
-0.65
0.06
Results
Spread
Spread Trading
Intra-Commodity Spread Trading Strategies
Intra-Commodity Spread Trading
Futures Prices are Increasing
Futures Prices are Decreasing
Spread is Long FPt, T+n (changing faster) Long FPt, T+n (changing slower)
Expanding Short FPt, T (changing slower) Short FPt, T (changing faster)
Spread is Long FPt, T (changing faster) Long FPt, T (changing slower)
Shrinking Short FPt, T+n (changing slower) Short FPt, T+n (changing faster)
Spread Trading
Inter-Commodity Spreads
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A spread between two different but related commodities is called an
inter-commodity spread.
Traders initiate inter-commodity spread position by simultaneous
purchase and sale of futures contracts for two different but related
commodities with the same or different delivery months.
Example: A trader expects that maize and wheat futures prices will fall
and the maize futures price will fall faster than the wheat futures price
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On 02 February 2013: Jul Maize futures price was 392.50 cents/bushel
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Jul Wheat futures price was 588.75 cents/bushel
The Jul Maize-Wheat spread was 196.25 cent/bu.
Spreading Strategy: Short Jul Maze Fut. & Long Jul Wheat Fut.
Spread Trading
Inter-Commodity Spreads
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On 26 February 2013: Jul. Maize futures price was 368.50 cents/bushel
Jul Wheat futures price was 533.25 cents/bushel
The Jul Maize-Wheat spread was 154.75 cent/bu.
Spread Trade-1
Spread Trade-2
2-Feb-13 Buy 1
Sell 1
26-Feb-13 Sell 1
Buy 1
Results
Spread
Spread Trading
Inter-Commodity Spreads
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On 26 February 2013: Jul. Maize futures price was 368.50 cents/bushel
Jul Wheat futures price was 533.25 cents/bushel
The Jul Maize-Wheat spread was 154.75 cent/bu.
Spread Trade-1
Spread Trade-2
Spread
2-Feb-13
Buy 1 Jul Maize contract at 392.50
Sell 1 July Wheat contract at 588.75
196.25
26-Feb-13
Sell 1 Jul Maize contract at 368.50
Buy 1 Jul Wheat contract at 533.25
164.75
-24.00
55.50
31.50
Results
Spread Trading
Inter-Commodity Spreads: Trading Strategy
Inter-Commodity Spread Trading
Futures Prices are Increasing Futures Prices are Decreasing
Spread is Long FPit, T (changing faster) Long FPit, T (changing slower)
Expanding Short FPjt, T (changing slower) Short FPt, T (changing faster)
Spread is
Shrinking
Long FPjt, T (changing faster) Long FPjt, T (changing slower)
Short FPit, T (changing slower) Short FPit, T (changing faster)
Spread Trading
Inter-Market Spreads
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Inter-market spread trading involves simultaneous purchase and
sale of (the same or different month) futures contracts of the same
(or related) commodity(ies) in two different exchanges.
Since wheat futures are traded at four different exchanges in the
Midwest, there is an opportunity for trading on any changes in
price differences between wheat contracts at different exchanges.
Other examples include spread trading between gold futures at
Chicago, New York, or London exchanges.
Inter-market price spreads are a variant of inter-commodity
spreads.
The basic rules for spread trading are also the same.
Spread Trading
Complex Spreads
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A spread position can also be initiated by simultaneous purchase and
sale of complex commodities.
A popular agricultural complex futures spread is the crush spread.
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The crush spread is the simultaneous purchase (sale) of beans (or seed)
futures and sale (purchase) of oil and meal futures.
The crush spread is the expected gross processing margins of the
processor. (See Edwards and Ma, pages 390-391).
A well-known energy futures spread is called the crack spread.
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A crack spread is the simultaneous purchase (sale) of crude oil and sale
(purchase) of petroleum products (e.g., heating oil and gasoline) futures.
The magnitude of this spread reflects the costs of refining crude oil into
petroleum products. (See Edwards and Ma, pages 398-399).