The practice of buying one futures contract and selling another that is similar in nature is known as spread trading—specifically, futures spread trading. The goal of a futures spread is to profit from the change in the price difference between the two related futures contracts involved. Simply, a futures spread trader isn’t necessarily concerned with the direction of the underlying market. Instead, the trader is speculating on the relationship (spread) between the prices of the two contracts in question. Two basic futures spreads exist: the intracommodity spread and the intercommodity spread.
- Intracommodity spread. In reference to a futures spread, there are a plethora of interpretations or meanings. However, the most commonly used spread strategy is the intracommodity spread, which is often referred to as a calendar spread. Specifically, this entails simultaneously holding a long position in one contract month of a specific commodity and a short position in another contract month of the same commodity.
For example, a grain trader might buy a July corn futures contract and sell a December corn futures contract. Whether the position is a winner or a loser doesn’t depend on whether corn prices go up or down; instead, it depends on how much more July corn increases relative to the December contract or how much less it decreases. Specifically, it is concerned with whether the spread widens or narrows.
- Intercommodity spread. Don’t get intracommodity and intercommodity spreads confused. The prefix intra denotes that the spread is with the same commodity; the prefix inter indicates that the spread is between two different but related commodities. As you can imagine, due to less obvious correlation between the components of an intercommodity spread relative to those in an intracommodity spread, intercommodity spreads tend to be much more volatile and expose traders to more risk.
An intercommodity spread consists of purchasing a futures contract in a given delivery month and simultaneously holding a short position in a related commodity market but the same delivery month. An example of popular intercommodity spreads include the crack spread (spreading crude oil against unleaded gasoline and heating oil) and the crush spread (spreading soybeans against soybean oil and soybean meal).
Similar to an option spread that can have its own quote, a futures spread can also be referenced in terms of a package. Consequently, spreads are traded in a separate trading pit located near the pit in which outright futures are traded, or electronically through designated networks and market makers. This enables traders to name the spread price and place the order to execute both sides of the position on a single ticket.
For example, if July corn futures are trading at $6.00 and December corn is trading at $7.10, the bid/ask spread on this particular intracommodity spread might be $1.10/$1.12. Thus, a spread trader could buy the spread for $1.12 or sell the spread for $1.10, or choose to work a limit order at an alternative price. Alternatively, a spread trader could choose to execute each leg of the spread separately, as opposed to a package, by executing two order tickets—one for the July corn futures and one for December.