If you have made it to this lesson and all the previous ones are clear to you, please accept my congratulation. Now you are ready to start building your own spreads.
In the last part of the series, I have revealed that the spot price acts as a magnet on the term structure and this effect usually works stronger on closer futures contracts. Therefore:
- if spot price is rising, closer contracts rise faster
- if the spot price is falling, closer contracts fall faster.
How do we build an interdelivery spread?
We know that interdelivery spread is simply the price difference of two contracts within the same commodity. For example, the difference between July and December corn contract. And we already know how we can trade this spread. We buy one of the contracts and sell another at the same time (LONG-SHORT). Now the question arises: which contract we should buy in a given situation and which, on the contrary, we should sell.
Let’s suppose that based on our analyzes, we expect a rise of some commodity price (bull market). As we have already said, in the case of a rising market, it is more likely that the closer contracts will rise faster. Therefore, we buy the closer contract sell the more distant one.
Our spread will look like this: CLOSER – MORE DISTANT. And this is our desired BULL SPREAD.
When the price of the commodity actually goes up, the first leg (long leg) will be profitable. The other leg (short leg) will be losing. However, this is normal for interdelivery spreads, and we’re fine with it. The important thing is that the profit from the first leg will be higher than the loss from the second leg of the spread. In the end, our spread as a whole will increase and we will be profitable.
But if we’re wrong, the short leg will act as a great insurance. In the event of a sudden drop in the price of the commodity, the long leg will be logically losing. However, thanks to the hedging of the opposite position, our overall loss will be much lower because the short leg (more distant contract) will be profitable. And that is why interdelivery spreads are less risky compared to outright futures.
It is now clear that if we speculate that price of some commodity will fall, we have to use the exact opposite strategy – BEAR SPREAD. We are going to expect a bigger drop in the closer contract, so we will sell the closer contract and buy the more distant contract. The resulting spread will be the opposite of the bull spread, i.e. the MORE DISTANT- CLOSER.
Everything else is the same as with the bull spread. If our speculation turns out to be correct, the gain on the short leg will be bigger than the loss on the long leg. Our spread will therefore rise, and we will make money. Otherwise, the other leg will act as a hedge and will reduce our overall loss.
So, that’s it. Now, the greatest secret of the spread trading has already been revealed – how to properly assemble a spread without any advice from some software.
With this 10th lesson, you already have a very good knowledge base for trading spreads. Now you can say that you understand how they are made, how they work, why they are expanding or narrowing. But don’t worry, we’re not finished yet. We have so much ahead of us. In the next part, we will return to the market structure and I will show a great tool from the SpreadCharts app for selecting the right spread – the contango histogram.