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Commodity spreads 12: How can you earn on non-trending markets?

14 Mar 2018,

You may think that this is not possible when you are reading the headline of this article. Something that does not move cannot make you money. But it is really possible, when it comes to interdelivery spreads. Of course, it is necessary to fully understand the principle of spread behavior as well as the structure of the market.

If you have understood well the previous parts of our spread series, you may already know where I am heading to. In this article on the spot price, I have basically revealed the principle of spread movement. Let’s now remind some part of it.

Spot price

The spot price is the price of the commodity with instant delivery. The term structure acts as a magnet. Therefore, it attracts more the closer contracts. This means that when the spot price grows, usually the nearest contracts are growing more than the others. When the spot price decreases, the closer contracts are decreasing more than the others.

Good. But what if the spot price does not move up or down? In other words, the market moves to the side.

As I have already written, the spot price is a commodity price with immediate delivery. No storage costs are therefore included here. Therefore, in the normal market, when nothing special happens, the more distant contracts are more expensive (the market is in contango). Storage costs are playing their role here.

But if the spot price does not move, contracts must gradually move closer to the term structure, ie. they approach by time to the spot price. Because the closer we are to the expiration, the less is the storage cost of the underlying commodity with future delivery. Therefore, the difference between the spot price and the futures price gradually shrinks.

Here again remember the connection with the magnet. The closest contracts are attracted to the spot price. So, we’re still talking about contango here. Therefore, the spreads between contracts are widening over time without the spot price shifting in any direction.

What spread we should choose?

Bear spread, or bull spread? Imagine a situation where the market is in a contango and the spot price is within a few weeks or months at a certain lower price range that does not significantly improve. At this time, a closer contract (say, December contract for corn) gradually approaches to the spot price. However, it converges faster than a more distant contract (for example, a March contract for the following year).

Does it remind you something? If not, return to this part. When we expect a closer contract to decline faster than a more distant one, we are choosing the bear spread strategy. This means that we sell the nearest contract and we buy the more distant one for hedging purposes. In our example, it is the ZCH19-ZCZ18 spreads on the corn.

If the contango is strong enough, it can even happen that the spread grows despite the slight growth of the underlying commodity. Which is unusual, because in this case, bull spreads should grow. Nice example is often coffee. This market is in the clear majority of time in the contango, we can see it on the contango histogram.

On the next chart you can see an example of how bear spread has grown (blue curve), while the price of coffee grew also quite significantly (purple curve).

These unusual movements of bear or bull spreads are also very useful for futures traders. Market structure behavior often tells us what’s going on “behind the curtain”. In other words, changes on the background of the market, which have not yet been materialized at the actual price of the underlying commodity. We can better predict future price movements of the underlying asset.

What’s next?

Next time, let’s look at what I promised already in the past – the choosing of the combination of contracts in particular situation and in a particular market.

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  1. Andreas

    Thanks alot for this series, it helps me to understand spread trading better.

    1. Quastic

      Dear Adnreas, we are happy to hear this and I hope you will enjoy also other part of our spread series….

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