The Daily Reckoning PRESENTS: Next to options trading, spread trading confuses more new traders than any other type of trading order. Luckily, our resident commodities guru, Kevin Kerr, is here to explain. Read on…
It’s actually quite simple if you don’t let all the jargon make you nervous. Basically, what you’re doing is taking a simultaneous long and short position in an attempt to profit. The profit comes from the differential, or “spread,” between two prices. A spread can be established between different months of the same commodity (called an interdelivery spread), between the same or related commodities, usually for the same month (intercommodity spread), or between the same or related commodities traded on two different exchanges (intermarket spread).
Spread Trading: Getting Started
You can enter a spread order at the market or you can designate that you want to be filled when the price difference between the commodities reaches a certain point (or premium). Take this spread example: We want to buy 1 June Live Cattle and Sell 1 August Live cattle when the August cattle contract is 100 points higher than the June contract. The order would read something like this:
BUY 1 JUNE LIVE CATTLE, SELL 1 AUGUST
LIVE CATTLE PLUS 100 TO THE AUGUST SELL SIDE.
Sounds confusing but it’s not, trust me. Again, all this means is that you want to initiate or liquidate the spread when the August cattle contract price is 100 points higher than the June cattle. These days, most exchanges don’t report spread transactions on their quote boards, but a few do. The best way is to find out from your broker who will call the trading floor or the order desk and ask them to get a “fresh quote.” Another way to figure out where a spread may be is to take the two prices and simply add or subtract one from the other. Always confirm this with your broker or the trading floor before entering any spread trade.
Spread Trading: Condor, Crack, Crush…
Just like everything in commodities, after you get used to the basics of spreads you’ll become aware of more complex strategies that include but are not limited to things like: Condor spreads, Crack spreads, Crush spreads–the list goes on ad infinitum. No, a condor isn’t some exotic bird of prey, it’s just trading-ese for a rather exotic spread trade. Condor spreads are sometimes referred to as “elongated butterflies.” That helps a lot, right? Let’s try another approach.
Take a long call condor spread. This bird consists of a long call of a lower strike, one short call of a second strike, one short call of a third strike and, finally, a long call of a fourth strike. The calls have the same expiration, and the strikes are equal distance apart. Now you’re probably scratching your head saying…”When would I ever use this?” Exactly! A condor spread is such a specialized strategy that it’s hard to say what the individual’s reasoning would be for using it; it would be different on a case-by-case basis.
I will say that spread trading – even complicated spreads like condors – can have value for some investors. Now I’m in no way advocating this type of trading, even for the seasoned options trader like myself. The biggest and most glaring problem with these complex spreads are that the only person that usually makes money is your broker. Condor spreads, like butterfly spreads, involve significant transaction costs which make them prohibitive for option traders who do not qualify for major commission discounts. The cost of this position must be examined carefully before establishing it.
The best thing to do is avoid trading any of these complex option strategies altogether. The risks of these option spreads far outweigh the advantages, and sometimes are far more hassle then they could ever be worth.
Some other types of spreads are more mainstream and do offer good opportunity. Two of those involve a main commodity that has products created or derived from it. A crush spread, for example, is simply a spread between soybeans and soybean meal and or soybean oil, sometimes called “putting on the crush.” A crack spread has nothing to do with illegal drugs; it’s the same type of spread as the crush, only involving crude oil and unleaded gasoline and /or heating oil.
Spread Trading: Learning Process
Let me interrupt myself for a second–I know all of this lingo can sound like mumbo jumbo, but rest assured that as you need to know these things you will. I myself, when I was first introduced to the markets, felt completely lost. I was utterly bombarded with a whole spectrum of new expressions and terms my first few weeks on the trading floor. While the old saying “fake it till you make it” worked for me, I suggest instead finding a broker or trading mentor, much like my readers have found in me. Use this person, ask questions, solicit advice, and whenever you’re not sure of what the terminology means, ask.
In my experience, people usually like nothing better than to talk about themselves; they like to teach someone something they know. So never hesitate to ask the questions; after all, it’s the only way you’ll learn.
Spread Trading Pros vs. Cons
Spreads can be very valuable and profitable but it’s important to start with the basics and then move on to the more exotic stuff when and if appropriate. Whenever I have an important decision to make I make two lists, Pro vs. Con. Here are some basic pros and cons of spread trading:
Spreads in commodity futures offer lower margin rates because these strategies usually carry less risk. (We’ll talk more about margins in a minute.)
Spreads are usually less volatile and prices move less quickly, which can be good for beginners who may be intimidated by the speed and price fluctuations of a single outright trade in the futures market.
Spreads offer unique hedging opportunities in a variety of commodities.
Certain types of spread trading allow the trader to pay less in margin, funding the purchased future or option with the sale of the other side of the spread, thus reducing initial costs.
Spread trading has much higher transaction (commission) costs because you’re using more than one trading vehicle. That’s why it’s even more important for a spread trader to have an excellent entry and exit point, because every penny will count.
Spreads are often not traded “outright”; in other words on their own in some commodities, so you must “leg” into them, which can be tricky for the novice. (More about outrights vs. legging into trades in the section on “Locals,” later on.)
Spreads can be less liquid than other trades, which could prove to be disastrous if you’re trying to get out of a position in a hurry.
Spreads have limited profit potential most of the time. For example, if a trader buys July corn and sells December and the July rallies but the December contract doesn’t really fall by much, and in fact rallies too, then the trader’s profits would be limited and the extra commissions would cut into what little profit the trader made.
Spread trading can be confusing, especially to the newer trader.
My final word on spread trading: It can be effective, but before entering into any spread trade figure out if you really have a reason to be using this type of trade, what purpose does it serve? If the answer is clear to you then go right ahead. Remember the most important thing to watch with spreads are those pesky transaction costs – they can really add up, fast.
Here are some other articles about Spread Trading:
Bernanke’s Yield-Curve Confusionsby Frank Shostak
“The Fed Chairman has concluded that the consequent narrowing in the spread between the long-term and the short-term interest rates (flattening in the yield curve) may imply that the present interest rate stance of the U.S. central bank is either too easy or too tight.”
Economic Realities by Gary Shilling
“Anticipated stock volatility remains at rock bottom. Spreads between yields on junk bonds and Treasurys are tiny as ample financing and loose lending keep corporate defaults at record lows.”
Financial “Trompe L’Oeil” by Eric Fry
“…the narrowing of spreads between long-dated crude futures and near-month contracts caught many “seasoned” oiltraders off guard. But eventually, they embraced thespread-narrowing trend as a relatively “low-risk”opportunity.”
Forcast: Partly Cloudy by Kevin Kerr
“By using spread trades and options in the energy markets, traders can maximize profit potential while limiting downside risk. Spread trades are exactly what they sound like. The most common spreads are those between the different trading months…”
Here are some resources about Spread Trading:
American Investment TrainingProvides the very best investment and financial training.
Daytrader Team Stock and options trading alerts and education for day trading and swing trading.
Man Spread Trading Focuses exclusively on financial market spread betting.
Spread Trading Joe Ross – Trading Educators.
World Spreads Spread Trading company thatoffers a full range of prices on the worlds equity, currency, interest rate and commodity markets in a low cost and tax efficient manner.
Looking for more on Spread Trading?
Visit theDaily Reckoning Archiveswhere you can search thousands of Daily Reckoning articles and reports.