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Commodity spreads 7: Why are the interdelivery spreads traded with lower risk?

19 Jan 2018,

From previous lessons, we already know everything so we can move on to the most important characteristics of the commodity spreads trading – precisely the interdelivery spreads – that is a lower risk than in the case of trading futures. Also, as an additional benefit, we can count on the lower margin. Today we’ll explain all those important parts.

 

Recap from the last time

We know from the last part that we can trade all types of spreads according to the formula: LONG – SHORT. That means buying one contract and selling the second contract at the same time. Because most commodity exchanges recognize this order as a single one, we do not have to trade these two positions separately. It is enough to choose a combo order and the broker will take care of everything.

However, I must point out that in the case of intermarket spreads, the broker does not have to guarantee that both legs of the spread will be filled in the same time. In the case of interdelivery spreads, it is guaranteed.

Interdelivery spreads

Now let´s focus on interdelivery spreads. From the 4th part of this series we already know why the prices of different contracts for the same commodity are different. The cause is the existence of two market conditions – contango and backwardation. So, we understand why the interdelivery spread is not zero, when traded as LONG-SHORT. I still must explain to you how it is possible that spreads are growing or narrowing. That’s what’s coming next. Let us now return to today’s risk topic.

Imagine that soon you expect a rise of the sugar price. So, you decide to buy a March contract (long position on SBH18). If you were a trader who trades purely futures contracts, buying a contract would be your final position.

However, if you are a spread trader, you will secure against this long position another counter position, selling another futures contract on sugar. Let’s say you sell more distant May contract (short position on SBK18). Therefore, you have opened a spread position with the name SBH18-SBK18, which is also called bull spread. But I do not want to make it too heavy here. What are bull and bear spreads will be explained in other lessons.

Spread as a form of hedging

In the end, you have bought and sold the commodity. A spread position is, therefore, de facto a form of hedging. Your long position was secured by the opposite short position. Futures contracts across the term structure do not move the same, but they move very similarly. Therefore, the loss on one side of the spread is largely compensated by the gain on the other side of the spread.

And, of course, you see now why trading spreads is less risky. Imagine that you only have a long position on sugar. This position will lose $ 1,000. However, if you are holding a spread, you are shorting another contract. And this position is logically on the contrary in the profit, say, $ 800. So, your loss is not $ 1,000, but just $ 200. That’s a huge difference.

Lower margin

From the nature of the interdelivery spreads comes that the average mid-term volatility of spreads is lower compared to futures. This fact is also acknowledged by brokers and is considered by the required margin. Here’s an example from the latest Spread report:

Margin to open the CLH18 oil contract – $ 2 405

Margin to open CLN18-CLM18 – $ 140

You can see that this is a big difference.

 

Intermarket Spreads

With the intermarket spread it is not that simple. Spread is composed of two different commodities. Just consider, for example, the spread between corn and wheat. When corn grows, it is likely that all corn contracts will grow. But that does not necessarily mean that wheat must also grow. Grain markets are, to some extent, connected. In many sectors, corn can be replaced by wheat and vice versa – for example, as feed or in the production of biofuels.

The relationship between these two commodities is, however, much more loose than between futures contracts within one commodity. No one is surprised when the corn grows, and the wheat falls. The risk for this type of spreads is therefore considerably higher and therefore the margin is higher too.

Lower capital

This results in a big advantage of the interdelivery spreads – smaller capital requirements compared to futures. And that’s logical. The risk of $ 1000 per futures contract requires a higher account than the risk of $ 200 per one spread.

Summary

Interdelivery spreads are having in comparison to futures following qualities:

Lower volatility – lower risk – lower margin – lower capital required

 What’s next?

Next time, we’ll explain another important thing, and that’s why we can make money on spreads. We will answer the questions why the price differences between futures contracts are not the same and why the prices of these futures do not move in the same way.

 

 

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