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Many investors use spread trading for tax benefits, higher profits on margined trading, and higher leverage. In essence, spread trading involves taking a related market and positioning yourself on opposite sides (usually involving different strike prices or expiration dates) for a higher profit potential in a low-risk environment.
“A spread trader always wants the long side of the spread to increase in value relative to the short side,” explains an article from RJO Futures. “This means the spread trader wants the difference between the spread to become more positive over time. Whenever a spread is quoted, it’s always a single price. You would never get a quote with the two individual prices. The price is figured by subtracting the back month from the front month.”
For those in commodity futures trading, RJO Futures also explains that commodity futures spreads are considered a lower risk, and you don’t have to be an expert to get started.
“Commodity futures spreads are less sensitive to market moves than a pure commodity future position, and can provide a more conservative addition to an existing futures trading portfolio,” it says.
Investors of any expertise level can take advantage of spread trading commodity futures, but you shouldn’t proceed blindly. Some strategies work better than others, and the more you experiment and understand the market, the better off you’ll be.
Start with Research
Spread trading takes extensive analysis of relative supply and demand, and since you’re doing it for two contracts instead of one, it can be a cumbersome task. However, most small speculators find it worthwhile because of the profit potential and low volatility.
All successful spread trades start with research on securities, earnings announcements, and other economic metrics. You might also subscribe to publications specializing in commodity futures or spread trading to stay up-to-date on the latest news, charts, meeting dates, quarterly reporting updates, dividend dates, analysts’ ratings, and more.
Start Small
Commodity futures traders without experience in spread trading shouldn’t do too much at one time. Because of the thorough research that’s required, spread trading can be precise, and small mistakes can ultimately yield major issues. By starting smaller than you think you can handle, you’ll get more in-depth, hands-on experience that will promote a growing strategy.
Contango and Backwardation Markets
A market is in a state called Contango, when the deferred months cost more than the front months. On a graph, it appears as an upward sloping curve. It might also be called a “normal market.”
A backwardation market is the opposite of Contango, when the forward contracts are trading higher than the deferred. This might also be referred to as “inverted” markets, and will appear with a downward, sloping curve on a graph. It usually indicates a substantial supply issue or an uneven increase in demand.
Spread traders can take advantage of trading in either backwardation or Contango markets for a lower-risk investment if they understand the factors affecting the slope. Watching the markets carefully and looking for that upward curve on trading graphs can help you make safer bets.
Track Market Changes
You’ll typically see the most movement in a market when the U.S. market first opens and during the first 30-60 minutes of a trading session. Speculators who apply their spread trading strategies in this window have higher potential for reward, but there’s also greater risk.
To lower your risk, try to invest in a market you understand, whether it’s Contango, backwardation, bear, bull, etc. Also, deal in commodities zones that you understand well. Staying up-to-date with the companies in a certain zone will make for more informed, low-risk trades.
Consider Automation
Investors who have a little more experience and understanding of the spread trading market will often develop a system of automation for potentially higher returns. If you automate the trades, there’s less manual intervention, which can remove human emotion and micro-management monitoring from each trade.
Building a system of automation can take time, and there will be periods of testing and learning from past mistakes. But after a time, this method of automation can make each trade easier and more profitable than the last.
Disclosure: I do not own any of the stocks mentioned in this article.
