1. Lecture 5 Spread Trading Primary Texts Edwards and Ma: Chapter 4 CME: Chapter 7

2. Spreads In addition to outright long and short positions, traders in futures markets commonly trade spreads. The price difference between two futures contracts is called the spread. For example, the July-September spread in wheat refers to the difference between July and September wheat futures prices. In general, an n-month price spread at a given time is defined as FP t, T+n − FP t T = Spread t,(T+n, T) Trading spreads is based on the expectation that the spread (i.e., the price difference) may vary over time.

3. Spreads: An Example

4. Spread Trading Traders initiate spread positions when they think that the price difference between the two contracts will change to their benefit before the trade is offset. In fact, traders do not care about the absolute prices of the contracts but only the price relationship. A spread position is initiated by the simultaneous purchase and sale of futures contracts on the same commodity but with different delivery months, or different commodities with the same delivery month, or different commodities with different delivery months. Since spreads involves holding both long and short positions, price changes in the underlying contracts generally result in simultaneous gains and losses in both sides (or legs) of the spread.

5. Spread Trading Why Trade Spreads? Spread positions are much less volatile than outright long or short positions Because of lower volatility, spread positions are considered to be less risky than taking an outright position in the market. Also, because of lower volatility, futures exchanges allow traders to post a smaller margin on such positions. The initial and maintenance margins for outright long or short CBT 2013 Corn futures contract are $2,700 and $2,000, respectively. The initial and maintenance margins for CBT 2013 Corn futures spreads are $540 and $400, respectively. Thus, trading spread is often viewed as a more conservative speculation strategy

6. Spread Trading Spread Trading Principals Taking a spread position is less risky than taking an outright position in the market. However, it is possible to lose on each side of a spread trade. In order to avoid such loss, the trader must consider three issues: Choosing the contracts to spread – look at historical prices and identify whether there is any systematic relationship between the price series. Know what the typical price relationship is, identify any potential abnormal change in prices and spread, and forecast correctly. Choose the appropriate timing of initiating and closing the spread position.

7. Spread Trading Intra-Commodity (Inter-delivery) Spreads A spread between different contract months in the same commodity is called an intra-commodity (or inter-delivery) spread. Traders initiate intra-commodity spread position by simultaneous purchase and sale of the same contracts but with different delivery months. Example: On 02 February 2013 Jul. wheat futures price was 588.75 cents/bushel Sep. wheat futures price was 612.75 cents/bushel The Jul-Sep wheat spread was 24 cent/bushel. Case 1: A trader expects that wheat futures prices will fall and the Jul. wheat futures price will fall faster than the Sep. wheat futures price Spreading Strategy: On 02 February 2013 the trader will Long Sep. Wheat futures & Short Jul. Wheat Futures

8. Case 1: Futures Prices are Falling and the Spread is Expanding Buy the contract the price of which is falling slower and sell the contract the price of which is falling faster Spread Trading Intra-Commodity Spreads: Trading Strategy

9. Spread Trading Intra-Commodity (Inter-delivery) Spreads Example (continued): On 27 February 2013 Jul. wheat futures price was 533.25 cents/bushel Sep. wheat futures price was 558.25 cents/bushel The Jul-Sep wheat spread was 25 cent/bushel. If the trader closed her spread position on 26 Feb. 2013, her net gain from the spread trading would be 1 cent per bushel

10. Spread Trading Intra-Commodity (Inter-delivery) Spreads Example (continued): On 27 February 2010 Jul. wheat futures price was 533.25 cents/bushel Sep. wheat futures price was 558.25 cents/bushel The Jul-Sep wheat spread was 25 cent/bushel. If the trader closed her spread position on 27 Feb. 2010, her net gain from the spread trading would be 1 cent per bushel

11. Case 2: Futures Prices are Falling but the Spread is Shrinking Buy the contract the price of which is falling slower and sell the contract the price of which is falling faster Spread Trading Intra-Commodity Spreads: Trading Strategy

12. Spread Trading Intra-Commodity (Inter-delivery) Spreads Example: A trader expects that wheat futures prices will fall and the Sep. wheat futures price will fall faster than the Jul. wheat futures price Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut. On 26 February 2013: Jul. wheat futures price was 533.25 cents/bushel Sep. wheat futures price was 548.25 cents/bushel The Jul-Sep wheat spread was 15 cent/bushel.

13. Spread Trading Intra-Commodity (Inter-delivery) Spreads Example: A trader expects that wheat futures prices will fall and the Sep. wheat futures price will fall faster than the Jul. wheat futures price Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut. On 26 February 2013: Jul. wheat futures price was 533.25 cents/bushel Sep. wheat futures price was 548.25 cents/bushel The Jul-Sep wheat spread was 15 cent/bushel.

14. Case 3: Futures Prices are Rising and the Spread is Expanding Buy the contract the price of which is rising faster and sell the contract the price of which is rising slower Spread Trading Intra-Commodity Spreads: Trading Strategy

15. Spread Trading Intra-Commodity (Inter-delivery) Spreads Example: On 02 February 2013 Jul. sugar futures price was 13.16 cents/lbs Oct. sugar futures price was 13.50 cents/lbs The Jul-Oct sugar spread was 34 cent/lbs Case 3: A trader expects that sugar futures prices will rise and the Oct. futures price will rise faster than the July. futures price Spreading Strategy: Long Oct. Sugar Fut. & Short Jul. Sugar Fut.

16. Spread Trading Intra-Commodity (Inter-delivery) Spreads Example: On 27 February 2013 Jul. sugar futures price was 13.87 cents/lbs Oct. sugar futures price was 14.22 cents/lbs The Jul-Oct sugar spread was 34 cent/lbs Case 3: A trader expects that sugar futures prices will rise and the Oct. futures price will rise faster than the July. futures price Spreading Strategy: Long Oct. Sugar Fut. & Short Jul. Sugar Fut.

17. Case 4: Futures Prices are Rising but the Spread is Shrinking Buy the contract the price of which is rising faster and sell the contract the price of which is rising slower Spread Trading Intra-Commodity Spreads: Trading Strategy

18. Spread Trading Intra-Commodity (Inter-delivery) Spreads Case 4 Example: A trader expects that sugar futures prices will rise and the Jul. futures price will rise faster than the Oct. futures price Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut. On 26 February 2013: Jul. Sugar futures price was 13.87 cents/lbs Oct. Sugar futures price was 14.15 cents/lbs The Jul-Oct wheat spread was 28 cent/lbs

19. Spread Trading Intra-Commodity (Inter-delivery) Spreads Case 4 Example: A trader expects that sugar futures prices will rise and the Jul. futures price will rise faster than the Oct. futures price Spreading Strategy: Short Sep. Wheat Fut. & Long Jul. Wheat Fut. On 26 February 2013: Jul. Sugar futures price was 13.87 cents/lbs Oct. Sugar futures price was 14.15 cents/lbs The Jul-Oct wheat spread was 28 cent/lbs

20. Spread Trading Intra-Commodity Spread Trading Strategies

21. Spread Trading Inter-Commodity Spreads A spread between two different but related commodities is called an inter-commodity spread. Traders initiate inter-commodity spread position by simultaneous purchase and sale of futures contracts for two different but related commodities with the same or different delivery months. Example: A trader expects that maize and wheat futures prices will fall and the maize futures price will fall faster than the wheat futures price On 02 February 2013: Jul Maize futures price was 392.50 cents/bushel Jul Wheat futures price was 588.75 cents/bushel The Jul Maize-Wheat spread was 196.25 cent/bu. Spreading Strategy: Short Jul Maze Fut. & Long Jul Wheat Fut.

22. Spread Trading Inter-Commodity Spreads On 26 February 2013: Jul. Maize futures price was 368.50 cents/bushel Jul Wheat futures price was 533.25 cents/bushel The Jul Maize-Wheat spread was 154.75 cent/bu.

23. Spread Trading Inter-Commodity Spreads On 26 February 2013: Jul. Maize futures price was 368.50 cents/bushel Jul Wheat futures price was 533.25 cents/bushel The Jul Maize-Wheat spread was 154.75 cent/bu.

24. Spread Trading Inter-Commodity Spreads: Trading Strategy

25. Spread Trading Inter-Market Spreads Inter-market spread trading involves simultaneous purchase and sale of (the same or different month) futures contracts of the same (or related) commodity(ies) in two different exchanges. Since wheat futures are traded at four different exchanges in the Midwest, there is an opportunity for trading on any changes in price differences between wheat contracts at different exchanges. Other examples include spread trading between gold futures at Chicago, New York, or London exchanges. Inter-market price spreads are a variant of inter-commodity spreads. The basic rules for spread trading are also the same.

26. Spread Trading Complex Spreads A spread position can also be initiated by simultaneous purchase and sale of complex commodities. A popular agricultural complex futures spread is the crush spread. The crush spread is the simultaneous purchase (sale) of beans (or seed) futures and sale (purchase) of oil and meal futures. The crush spread is the expected gross processing margins of the processor. (See Edwards and Ma, pages 390-391). A well-known energy futures spread is called the crack spread. A crack spread is the simultaneous purchase (sale) of crude oil and sale (purchase) of petroleum products (e.g., heating oil and gasoline) futures. The magnitude of this spread reflects the costs of refining crude oil into petroleum products. (See Edwards and Ma, pages 398-399).