What it means
Many commodities move together because they share drivers, such as weather, demand or a common input. Corn and wheat, for example, both compete for farmland and are used in animal feed.
A trader who thinks the price gap between two related commodities will change can take opposite positions in each. The trader goes long on one contract, meaning buys it, and short on the other, meaning sells it.
If the whole market rises or falls, the gains on one side partly offset the losses on the other, so the position is less exposed to the market's general direction. What matters is whether the gap between the two prices widens or narrows.
Margin, which is the deposit required to hold a futures position, is often lower for spreads than for outright positions. Exchanges recognise that a spread is less risky because the two legs offset each other.
This allows traders to hold the position with less capital tied up. Producers and users also use spreads.
A company that processes one commodity into another, for example crushing soybeans into oil and meal, is exposed to the gap between input and output prices. Trading the spread helps lock in the processing margin.
The trade is not risk free. The relationship between the two commodities can break down because of a crop failure, a policy change or a shift in demand for just one of them.
Each leg is also still subject to price moves, so losses on both can occur at once. Costs include commissions on both legs and the cost of tying up margin.
Traders usually consider the spread's historical range, seasonal pattern and the fundamentals of both markets before entering.
In practice
Real-world examples.
Example
A trader believes that high corn prices will push farmers to plant less wheat next season. He buys wheat futures and sells corn futures, aiming to profit if wheat strengthens relative to corn. Margin on this position is usually lower than on an outright position because the two contracts offset each other.
Example
An oilseed processor is concerned that the gap between the price of soybeans and the price of the products made from them will shrink. It trades the spread to lock in its processing margin ahead of the season.
Example
A fund manager wants exposure to energy but fears a sudden fall in the overall market. She buys crude oil futures and sells natural gas futures, so that her profit depends on the gap and not on both falling together.
Formula
Calculation
Spread = Price of commodity A - Price of commodity B
Profit = Change in spread (in the trader's favour) x Contract size
A trader expects wheat to weaken relative to corn. She sells one wheat contract at $6.00 per bushel and buys one corn contract at $4.50 per bushel, so the spread (wheat minus corn) is 6.00 - 4.50 = $1.50. Each contract covers 5,000 bushels.
Later, wheat is $6.10 and corn is $4.80, so the spread is 6.10 - 4.80 = $1.30. The spread has narrowed by 1.50 - 1.30 = $0.20 in her favour. Corn gain: (4.80 - 4.50) x 5,000 = $1,500. Wheat loss on the short: (6.10 - 6.00) x 5,000 = $500. Net profit = 1,500 - 500 = $1,000, which matches 0.20 x 5,000 = $1,000.Case study
Seen in the real world.
Prairie Gold Traders is an illustrative, fictional trading firm that specialises in agricultural futures. An analyst noticed that the spread between wheat and corn was well above its historical average.
The firm sold one wheat contract and bought one corn contract, each of 5,000 bushels, when the spread was $1.80. Over six weeks the spread fell to $1.40, a narrowing of $0.40, which produced a profit of 0.40 x 5,000 = $2,000 before commissions of $60.
The net result was $1,940. In this illustrative story, the firm noted that the trade worked because both legs responded to the same market forces, and it kept the position small because a sudden crop problem in one commodity could have reversed the result. The analyst kept a written note of the entry spread, the exit target and the level at which the trade would be abandoned, so that the decision to close did not depend on mood. Whenever possible, the firm also reviews the correlation between the two prices before opening a position, since a weak link between them makes the spread unpredictable.
Watch out
Common mistakes.
- Assuming a spread is risk free, when the gap can move against the trader and each leg can lose money.
- Forgetting that different contracts may have different sizes or units, which changes the profit on each leg.
- Ignoring commissions on both legs, which reduce a small expected gain.
Questions
People also ask.
What is the difference between an intercommodity and an intracommodity spread?
An intercommodity spread uses two different commodities, while an intracommodity spread uses two delivery months of the same commodity.
Why is margin lower on spreads?
The two legs offset each other, so the exchange regards the combined position as less risky than a single outright position.
Who uses intercommodity spreads?
Speculators looking for relative value, and businesses such as processors that want to protect the gap between input and output prices.
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