In the last part of our series, we have explained a very important thing – interdelivery spreads are basically a form of hedging. And thanks to this, we can trade them at a lower risk compared to futures contracts. That’s great. But we still must understand how we can earn from this type of spread? How it is possible that the spreads are either growing or narrowing?
Here it is clear. Let’s say we are holding the intermarket spread between wheat and corn (eg ZWN18-ZCN18). The ideal situation would be when the wheat contract will grow, and the corn contract will fall. This can be easily imagined. This situation can be seen in the following scheme:
But what about the interdelivery spreads? Both legs of the spread belong to the same commodity. We already know why contracts with different expiration have different prices. The reason is the existence of a market structure – contango or backwardation. But how is it possible that the spreads change? For example, if a commodity grows, all contracts should grow as well, isn´t it?
If that would be the case and all contracts would grow or fall equally, it would mean that the term structure does not change. In other words, it would only move up or down. But try the SpreadCharts.com to see the current term structure on the gas and compare it with the term structure a month ago. You will see a really big difference.
The arrow points to the option where you can select a term curve for another date
You probably know what I mean by this. Term structure curve does not always have the same shape! This is a very important fact that must be understood by all spread traders but also by the futures contract traders. The term structure may stretch or flatten, may become curly, and may even change the shape from contango to backwardation.
Imagine the term structure as a stretched rubber band. Mark two points on it, among which the vertical difference will represent a certain spread. And if you stretch this rubber band differently, the distance between the marked points (or our spread) will increase or decrease.
Now we move the two points of our rubber band to the term structure. Any change on this curve will then also represent movements of the interdelivery spread. And that’s why we can trade it.
From today’s lesson, you should remember one very important fact – the term structure is NOT STATIC. Markets are dynamic, changing over time. Different market conditions are reflected by our interdelivery spreads. We can read a lot from their behavior. Spread development is therefore not only important for spread traders, but also for futures traders. If we understand the spread, we can reveal the hidden part of the market and we can better estimate future development.
Now we are ready to learn how to set a spread trade. I will explain the strategies of bull and bear spreads. You certainly have something to look forward.