Commodity spreads 7: Why are the interdelivery spreads less risky?

We already know the basics from the previous lessons so we can move on to the most important characteristics of the interdelivery commodity spread trading that is a lower risk compared to outright futures. Also, as an additional benefit, they are less capital intensive due to lower margin requirements. We’ll explain all these things today.

Recap from the last time

We know from the last part that we can trade all types of spreads according to the formula: LONG – SHORT. That means buying one contract and selling another contract at the same time. Because most commodity exchanges recognize this order as a single one (for interdelivery spreads), we do not have to trade these two positions separately. It is enough to choose a combo order and the broker will take care of everything.

However, I must point out that in the case of intermarket spreads, the broker does not have to guarantee that both legs of the spread will be filled at the same time. In the case of interdelivery spreads, it is guaranteed.

Interdelivery spreads

Now let’s focus on interdelivery spreads. From the 4th part of this series we already know why the prices of different contracts for the same commodity are different. It’s because the existence of two market conditions – contango and backwardation. So, we understand why the interdelivery spreads are not always zero. What we don’t know yet is why the spreads are expanding or narrowing over time. We’ll get back to it in some future article. Now let’s get back to today’s topic.

Imagine that you expect the sugar price to go higher. So, you decide to buy a March contract (long position on SBH18). If you were an outright futures trader, buying a contract would be your final position.

However, if you are a spread trader, you will hedge against this long position with another counter position, selling a different futures contract on sugar. Let’s say you sell more distant May contract (short position on SBK18). Therefore, you have opened a spread position on SBH18-SBK18, which is also called bull spread. But I do not want to make it too heavy here. What are bull and bear spreads will be explained in future lessons.

Spread as a form of hedging

In the end, you have bought and sold the commodity. A spread position is, therefore a form of hedging. Your long position was offset by the opposite short position. Futures contracts across the term structure do not move the same, but they move very similarly. Therefore, the loss on one side of the spread is largely compensated by the gain on the other side of the spread.

Now you see why spread trading is less risky. Imagine that you only have an outright long position in sugar. This position will lose for example $1,000. However, if you are holding a spread, you are shorting another contract. And this position is logically profitable, let’s say $800. So, your net loss is not $1,000, but just $200. That’s a huge difference.

Lower margin

Less risky nature of interdelivery spreads translates into lower volatility compared to futures. This fact is also acknowledged by brokers and is reflected by lower margins. Here’s an example from the latest Spread report:

Margin to open the CLH18 oil contract: $2 405

Margin to open CLN18-CLM18 spread: $140

You can see the big difference.

Intermarket Spreads

It is not so simple with intermarket spreads. These spreads are composed of two different commodities. Just consider, for example, the spread between corn and wheat. When corn price rises, it is likely that all corn contracts will go higher. But that does not necessarily mean that wheat must also rise. Grain markets are, to some extent, interconnected. In many sectors, corn can be replaced by wheat and vice versa – for example, as feed or in the production of biofuels.

The relationship between these two commodities is, however, much looser than between futures contracts within a single commodity. No one is surprised when the corn price increases while the wheat falls. The risk for this type of spreads is therefore considerably higher and therefore the margin requirements are higher too.

Lower required capital

This results in a big advantage of the interdelivery spreads – smaller capital requirements compared to outright futures. It’s logical. Risking $1000 on a futures contract requires a much larger account than risking just $200 on a spread.

Summary

Interdelivery spreads have the following advantages compared to outright futures:

Lower volatility -> lower risk -> lower margin -> lower capital required.

 What’s next?

Next time, I’ll explain another important thing, which is why we can make money on spreads. We will answer the questions why the price differences between futures contracts are not constant over time and why the prices of these futures do not move identically.