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Trading Commodity Spreads

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Many professional commodity traders focus on trading spreads. A spread involves the simultaneous buying of one commodity and the selling of the same or similar commodity. Using spreads often cuts down on the risk of buying a straight commodity position.

Some of the more popular spreads are in the grain markets. A common trade is to buy one grain and sell another grain. For example, a trader might buy December corn and sell December wheat. The premise for the trade is that the trader expects the corn market to be stronger than the wheat market. As long as corn moves up more than wheat or doesn’t fall as much, the trader can make a profit.

Spreads can also be done within the same commodity. For example, a trader can buy July corn and sell December corn at the same time during spring. This is called a bull spread. The front month typically moves more than the further out months. If someone was expecting corn prices to move higher during the year, this would be a considered a proper trade.

Corn prices can move 10 plus cents each day, while spreads usually only move a fraction of that amount. They are considered a more conservative strategy than solely buying or selling a straight futures contract. The margin is also much lower on a futures spread than it is on a straight futures contract.

Types of Commodity Spreads

A trader can find almost any type of commodity spread to meet any outlook on the markets. This not only applies to an outlook on one market, but it can apply to an outlook on multiple markets. Below are the types of futures spreads that a trader can utilize.

Intra Market Spreads - These are commonly called Calendar Spreads. They involve the buying and selling of different contract months within the same commodity. For example, a trader can buy May soybeans and sell November soybeans.

Inter Market Spread - This type of futures spread involves buying and selling of different but related commodities. The commodities usually move closely together, but there may be particular reasons why one commodity might be stronger than the other. For example, a trader could buy silver and sell gold.

Inter Exchange Spreads - The inter exchange spread involves the simultaneous purchase and sell of the same underlying commodity, but traded on different exchanges. An example of this trade would be buying December wheat futures traded on the CME Group and selling December wheat futures traded on the Kansas City Board of Trade.

Trading Commodity Spreads

A trader should be more aware of the price spread between the two contracts rather than actual prices. The price spread is the difference between the two contracts. For example, July corn is trading at $6.05 and December corn is trading at $5.75. The spread is 30 cents. If July corn moves up faster than December corn, the spread will increase. Therefore, buyers of the spread will make a profit.

The more conservative nature of commodity spreads does not necessarily mean there is less risk. Anyone who has traded spreads over a period of time knows that things can sometimes go awry. Weather conditions and crop reports are but a couple of the things that can cause spreads to jump more than normal.

A worse case scenario is when the futures contract you buy moves sharply lower and the contract you sell moves sharply higher. Two fairly correlated commodities like corn and wheat can do this. It is not a good feeling when you are looking for a five cent gain on a spread and overnight you loose 15 cents because of crop news coming out of China. The key here is to always be aware of the risks even though you are using a more conservative strategy.

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