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Contract spreading grows

Commodity spread trading is not for the faint of heart. It has long been held as a specialists market but as of late has come more into play as another way to express bullish or bearish sentiment with less margin money. That is not to say they are less risky but the participating futures exchanges will give you credit for owning one against another.

Traditionally the price difference between two deliverable months has had to incorporate the cost of carrying the commodity which is made up of insurance on stored commodity, storage costs and interest rates payments for the capital needed to own and store the commodity.

When the nearer month (spot) is priced lower than the further out month we call this contango and this is the normal price pattern and expectation in the market for the simple reason of the above storage, insurance and interest rate payments.

The opposite effect is called backwardation and occurs at times of short term stresses in the market as well as ‘one off’ events.

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The above chart is the July/Dec corn spread going back to last April 2011. As you can see, the volatility of the spread can be just like that of a single underlying contract. Over the last year you can see that the spread has traded as low as 24.75 and as high as 126.5. Over a dollar move from high to low in a year is a good example of actually how much these spreads can move. What this spread represents is old crop vs. new crop and whether or not we have a good supply of corn in the pipeline. If the weather has been good and we have planted a lot of corn acres but we don’t have enough corn in the short term for our needs you may see that spread move back towards our highs of 126.5. If our short term needs are suddenly met but the weather has taken a turn for the worse you may even see that spread trade below zero where we have a contango situation which would be the normal scenario. This spread is a very popular vehicle as it pits our short term needs against the crop in the ground.

Another popular spread is the spread of this year’s crop vs. next year’s crop. Let’s take a look at Dec12/Dec13. 

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The graph above shows us that the high was set on 9/12/11 of this year at 58.25 and the low was set 11/25/11 at -7.25. Again, this is a good example of how much these spreads can actually move and shows us that 0 is not the bottom. These spreads can all trade at a negative which would be contango. This year we have had some short term supply scares and that has put a lot of our spreads into a contango situation rather than the backwardation that one would normally expect.

Common Bean Spreads

As with corn, beans also have some popular spreads that are closely watched. The first is the July12/Nov12. We see that the high was put in on 8/29/11 at 83.5 and the low was put in on 12/09/11 at -0.5. And if you step back from the chart I think you would agree that the ride from last April to this April has been a fairly volatile one. Now let’s take a look at Nov12/Nov13. 

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Look at the move this spread has made since the end of March. That is why these spreads are sometimes named ‘career ruiners’.

Options on Spreads (CSOs or commodity spread options)

Now, just to complicate things, we have introduced options contracts on spread prices. Slowly but surely they have gained interest and the volumes continue to rise.

A great example on how to trade these spreads without risking your career would be to buy puts or calls on the spread itself. So, for instance, we could ask the pit for a price in the SX2/SX3 150 calls or the 100 puts.  The options trade just like regular options and expiry you receive the spread. So the underlying price is the spread and the options are priced off of the underlying. Since their inception the CSO’s have become a great way for those spread traders to either enhance their return or express an opinion without ‘betting the farm’.

Scott Shellady is an options specialist, trader and derivatives manager for ICAP Energy LLC in Chicago.

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