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Commodity spreads 6: How to trade commodity spreads?

17 Jan 2018,

Welcome to another part of our spread series. We already know quite a lot of things. We know what are commodities and spreads, we have revealed what is behind the existence of the spreads, we have explained what is contango and backwardation. But we still must explain one important thing – how to trade the spreads.

 

Homework

Let´s start with the checking of homework from the 4th part of the series. Its goal was to find the spread on the term structure on corn between the futures contract expiring in March and the contract expiring in July. In the following chart, you see the arrow that represents our spread. The size of this arrow simply means the price difference between the two contracts.

 

 

Simple as that! We use the basic mathematics, nothing more, nothing less. Later, I will explain to you that spreads can also be negative. But I do not want to jump too much forward right now. Now comes the question how we buy this spread?

Two contracts – how to work with them?

This causes probably the biggest worries when someone wants to discover what are commodity spreads. Here are the prices of two contracts. But how to trade only the price difference between them? When we trade the commodity, it is clear. Either we go long (we speculate on the growth, we are buying the contract), or we go short (we speculate on the decline, we sell the contract).

But what do we do with the spread? Do we have to follow the prices of both contracts? I understand. In my beginnings, I was as surprised as you might be right now. But do not worry, it’s much easier than it seems at first glance.

Here works a very simple quotation: LONG – SHORT. This means that one contract is bought, and the second contract is sold at the same time.

It may still look complicated. Surely, you’re asking how we can trade two contracts at the same time? In fact, it is easy. Commodity exchanges can recognize most of the spreads. Most brokers, therefore,p á provide a so-called combo order. You simply choose one contract long and second contract short on the platform to create a spread. In other words, you will look at the spread as a whole, like a single investment instrument, just like a futures contract or stock.

The beauty is in simplicity

So, if we have a spread on the platform and we are interested in opening the trade, we can either choose to buy (long position) or sell (short position). The broker then opens both contracts at once. So, there are no problems with two contracts. And to make the spread trading even easier, we will always speculate on a growth. So, we will always enter to the position as long and we will get out of position as short.

If we want to speculate on a drop in the spread price, we can do this by switching the legs of the spread. That means creating an inverted spread. That’s why you need to be very careful about the right settings! It does matter which contract we buy and which we sell! That’s what we’re going study in the next parts.

Two simple rules

From today’s lesson, you should take these two rules:

  1. LONG-SHORT
  2. speculation on growth

What’s next?

Next time, we will finally come to the explanation why it is less risky to trade spreads. I mean, of course, inter-delivery spreads. And perhaps you already know why it is. In another part, we’ll find out how it is.

 

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