Lecture 6 Spread Trading Primary Texts Edwards and Ma: Chapter 4 CME: Chapter 7

Lecture 6Spread Trading

Primary Texts

Edwards and Ma: Chapter 4

CME: Chapter 7

Spreads

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 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.

Wheat Futures Contracts: Settlement prices and nearmonth spreads

Settlement Settlement Change in

Con. Month 2-Feb-09 Spread 27-Feb-09 Spread Spread

Mar 563.75 510.50

May 576.75 13.00 521.50 11.00 -2.00

Jul 588.75 12.00 533.25 11.75 -0.25

Sep 612.75 24.00 558.25 25.00 1.00

Dec 633.00 20.25 579.75 21.50 1.25

Spreads: An Example

Spread Trading

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.

In fact, traders do not care about the absolute prices of the contracts but only the price relationship.

A spread position is initiated by the simultaneous purchase and sale of futures contracts on

the same commodity but with different delivery months, or different commodities with the same, 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 TradingSpread Trading Principals

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:

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

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 commodity but with different delivery months.

Example 1: On 02 February 2009 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

Spreading Strategy: On 02 February 2009 the trader will Long Sep. Wheat futures & Short Jul. Wheat Futures


Example 1: On 27 February 2009 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. 2009, her net gain from the spread trading would be 1 cent per bushel

Long Position Short Position Spread

2-Feb-09 Buy 1 September wheat contract at 612.75 Sell 1 July wheat contract at 588.75 24.00

27-Feb-09 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

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

Spread Trading Intra-Commodity Spreads: Trading Strategy


Case 2: A trader expects that wheat futures prices will fall and the Sep. wheat futures price will fall faster than the Jul. wheat futures price

Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut. On 27 February 2009: 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.


2-Feb-09 Buy 1 Jul.wheat contract at 588.75 Sell 1 Sep wheat contract at 612.75 24.00

27-Feb-09 Sell 1 Jul wheat contract at 533.25 Buy 1 Sep wheat contract at 548.25 15.00

Results -55.50 64.50 9.00

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



Example 2: On 02 February 2009 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 1: A trader expects that sugar futures prices will rise and the Oct. futures price will rise faster than the July. futures price

Spreading Strategy: Long Oct. Sugar Fut. & Short Jul. Sugar Fut.


2-Feb-09 Buy 1 Oct sugar contract at 13.50 Sell 1 July sugar contract at 13.16 0.34

27-Feb-09 Sell 1 Oct sugar contract at 14.22 Buy 1 July sugarcontract at 13.87 0.35

Results 0.72 -0.71 0.01

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



Case 2: A trader expects that sugar futures prices will rise and the Jul. futures price will rise faster than the Oct. futures price

Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut. On 27 February 2009: 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


2-Feb-09 Buy 1 Jul Sugar contract at 13.16 Sell 1 Oct Sugar contract at 13.50 0.34

27-Feb-09 Sell 1 Jul Sugarcontract at 13.87 Buy 1 Oct Sugar contract at 14.15 0.28

Results 0.71 -0.65 0.06

Futures Prices are Rising 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


Spread Trading Intra-Commodity Spread Trading Strategies

Intra-Commodity Spread Trading

Futures Prices are Increasing Futures Prices are Decreasing

Spread is Expanding

Long FPt, T+n (changing faster)Short FPt, T (changing slower)

Long FPt, T+n (changing slower)Short FPt, T (changing faster)

Spread is Shrinking

Long FPt, T (changing faster)Short FPt, T+n (changing slower)

Long FPt, T (changing slower)Short FPt, T+n (changing faster)

Spread Trading Inter-Commodity Spreads

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

On 27 February 2009: Jul Maize futures price was 392.50 cents/bushel

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

On 27 February 2009: 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.

2-Feb-09 Buy 1 Jul Maize contract at 392.50 Sell 1 July Wheat contract at 588.75 196.25

27-Feb-09 Sell 1 Jul Maize contract at 368.50 Buy 1 Jul Wheat contract at 533.25 164.75

Results -24.00 55.50 31.50

Spread Trading Inter-Commodity Spreads: Trading Strategy

Inter-Commodity Spread Trading

Futures Prices are Increasing Futures Prices are Decreasing

Spread is Expanding

Long FPit, T (changing faster)

Short FPjt, T (changing slower)

Long FPit, T (changing slower)

Short FPt, T (changing faster)

Spread is Shrinking

Long FPjt, T (changing faster)

Short FPit, T (changing slower)

Long FPjt, T (changing slower)

Short FPit, T (changing faster)

Spread Trading Inter-Market Spreads

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 TradingComplex Spreads

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. 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.

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).

Documents

Lecture 6 Spread Trading Primary Texts Edwards and Ma: Chapter 4 CME: Chapter 7