Spreading

A trading strategy consisting of simultaneously purchasing and selling of two different but related futures contracts is called spreading or a spread trade. The spread is simply the price difference between both the futures contracts. Traders start spread trades when they believe that the price differences between two contracts will alter to their benefit before the trade is of set.

A spread position is usually less risky than assuming a complete position in the market as the two positions are presumed to partly hedge each other. Spread positions can be classii ed into at least three broad categories: interdelivery spread, intercommodity spread, and intermarket spread.

When a spread trade entails futures with two dif erent contract months but written on the same underlying commodity, it is dei ned as an interdelivery spread. This is a broadly used kind of spread trade and two well-known strategies are the bull spread and the bear spread.

An intercommodity spread involves simultaneously purchasing one futures contract and the selling of a different but related futures contract that expires during the same month. Intercommodity spread traders must be careful about the choice of the two underlings they combine. Any two contracts will not do, contracts should be related so their prices normally increase or decrease jointly, or at least their price dif erence should tend to follow pattern.

Typical choices are: contracts whose underlings compete with each other—for example, cattle (beef) and hogs (pork) contracts at the Chicago Mercantile Exchange (CME); contracts whose underlings can be af ected by the same general event—a drought would af ect both corn and wheat, contracts at the CBOT; or contracts where one commodity is physically derived from another—for example, oil and gasoline contracts traded at Euronext Liffe.

Two famous intercommodity spreads are the crack spread and the crush spread. The name of the crack spread strategy is derived from the fact that "cracking" oil creates gasoline and heating oil.

The strategy is generated by buying oil futures and selling gasoline and heating oil futures, and the investment alignment permits the investor to hedge against risk as a result of the of setting nature of the underlings. A crush spread uses in the soybean futures market and consists of simultaneously purchasing soybean futures and selling soybean meal futures.

The intermarket spread involves buying and selling the same futures contract—same commodity and delivery month—at two dif erent exchanges, even in two diferent countries. Example of futures contract on a same underlying traded in various exchanges are, for example, gold futures, which are traded in Chicago, New York, and London exchanges or cotton, copper, and sugar that are traded in New York and London.

In many exchanges, the most famous spreads can be traded directly, that is, a trader would not need to give two different orders simultaneously; rather she would give only one order directly on the spread and quote the price dif erence of the two positions. Spread strategies are traded in both electronic and open outcry trading exchanges.

Spreading
Spreading
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