If you have get to this lesson and all the previous ones are clear to you, please accept my congratulation. Now you are ready to create your own spread without any help.
In the last part of the series, I have revealed that the spot price acts as a magnet on the term structure and this effect usually works stronger on closer futures contracts. Therefore:
- … if spot price is rising, closer contracts grow faster
- …. if the spot price is falling, closer contracts decline faster.
How do we build an interdelivery spread?
We know that interdelivery spread is simply the price difference of two contracts within the same commodity. For example, the difference between July and December corn contract. And we already know how we can trade this spread. We buy one of the contracts and sell another at the same time (LONG-SHORT). Now the question arises: which contract we should buy in the given situation and which, on the contrary, we should sell.
Let´s suppose that based on our analyzes, we expect a rise of the commodity price (bull market). As we have already said, in the case of a rising market, it is more likely that the closer contracts will grow. Therefore, logically, we buy a closer contract from a selected pair of contracts. And now we must sell a more distant contract from our pair.
Our spread will look like this: CLOSER – MORE DISTANT. And this is our desired BULL SPREAD.
When the market actually grows, the first leg (long leg) will be profitable. The other leg (short leg) will be in lost. However, this is normal for interdelivery spreads and we count on it. The important thing is that the profit from the first leg will be higher than the loss from the second leg of the spread. In the end, we will see growth on the chart and we will be profitable.
But if we’re wrong, the short leg will act as a perfect insurance. In the event of a commodity price drop, the long leg will be logically in lost. But thanks to the hedging of the opposite position, our overall loss will be much lower because the shorted leg (more distant contract) will be profitable. And that is why interdelivery spreads have a lower risk compared to trading futures.
It is now clear that if we speculate on the decline, we will use the exact opposite strategy – BEAR SPREAD. We are going to expect a bigger drop in the closer contract, so we will sell the closer contract and buy the more distant contract. The resulting spread will be the opposite of the bull spread, ie the MORE DISTANT– CLOSER.
Everything else is the same as with the bull spread. If our speculation is correct, the gain on the short leg will be bigger than the loss of the long leg. Our spread will therefore grow, and we will earn money. Otherwise, the leg will act as a security and will reduce our loss.
So, it is done. Now, the biggest secret of the spreads has already been revealed – how to properly create spread without having advice from some kind of software.
With this 10th lesson, you already have a very good base for trading spreads. Now you can say that you understand how they are made, how they work, why they are growing or falling. But do not worry, we’re not finished. We have so much ahead of us. In the next part, we will return to the market structure and I will show a great tool from SpreadCharts for selecting the right spreads – the contango histogram.