Commodity Spread Trading Techniques

By: George Angell

The following is an excerpt from George Angell's The Money Miracle

Trade the limited-risk spreads.  When futures contracts, especially in the agricultural commodities, trade in a “normal” pattern with nearby months of trading below distant months in a stair step fashion, the risk of buying the nearby month and selling a distant month is limited to the full cost of the carrying charges.  Accordingly, you can determine the risk in advance when you place the bull spread by subtracting the total difference in price between the two contracts from the full cost of carry.  Should bullish news occur, the nearby month can be expected to rise in price relative to the back month and you will profit on the spread.  Thus, using the limited-risk spread, you can achieve a good reward-to-risk ratio which, over time, should result in long-term profit.

Spreads require patience.  Spreads are not for short-term traders.  Because you are paying two commissions – one on the long position and another on the short position – you should think in terms of the long term when you trade spreads.  Spreads have been likened to “watching paint dry” because they tend to lack the thrills of high volatility in-and-out of trading.  For this very reason, however, they are ideal for the new trader.  They can result in dramatic profits when they work, and they can result in relatively small losses when they don’t work.  But patience pays.  Lastly, they are a good way for the new trader to get acquainted with the markets without risking a lot of money.

Spreads offer diverse strategies.  Spreads, like outright net position trades in which you either buy or sell a commodity, lend themselves to a number of market strategies.  You can place spreads to benefit from seasonal price moves or use them to exploit rising or falling markets.  Spreads work between different futures contracts of the same commodity, or between different (but related) commodities, such as cattle and hogs or soybeans and soybean oil.  You can even place spreads in commodities trading on different exchanges, such as wheat traded in Chicago and wheat traded in Kansas City.  And some spreads, due to the nature of carrying charges, are absolutely limited in risk (a rarity in the futures market) while capable of returning handsome profits.

Spreads have lower margins than outright positions.  Leverage, which is the key to enormous profitability of futures trading in general, plays an even more important role in spread trading.  As a rule, the leverage in the typical futures trade ranges from about 20 to 1 (when the required margin is just 5 percent of the total value of the contract), to about 5 to 1 (when 20 percent of the total value of the contract is required).  Yet even this leverage can be magnified by the use of spreads.  That’s because the margin on an outright net long or short position can often be ten times as high as the margin requirement on spreads in a comparable commodity.  Thus, dollar-for-dollar you get more profit-magnifying leverage when you trade spreads.

Do not use spreads to protect an outright position which has gone sour.  It is a bad practice to try to “lock-in” a loss by spreading when trading outright positions.  For instance, let’s say you are trading July soybeans and the market moves against you.  The intelligent thing to do is to take the loss.  Yet some traders will try to sell a November soybeans contract, say, to prevent additional losses.  The thinking is that you will deal with the initial loss at some time in the future, hopefully by “lifting” one leg on a bounce.  Don’t try this approach to spreading.  Instead, put on both legs at the same time and liquidate both legs at the same time.

Do not automatically assume that a spread trade is a low-risk trade.  Sometimes a spread may entail greater risks than the outright position.  This is especially true in non-storable commodities such as live cattle or live hogs.  In these commodities, in which the fundamentals can change quite rapidly, you could theoretically be long a month that goes down in price and short a month that rises in price.  The net result would be that you would lose on both legs of the spread.  There are low-risk spreads.  But, not all spreads are low-risk.
Avoid spreads involving soon-to-expire contracts.  You don’t want to be given delivery on your long position, so you should avoid trading into the delivery month.  As a rule, exit by the first day of the delivery month.  You also have to contend with commodities that have “no limits” during the delivery month since most commodities have the limits removed just prior to delivery.

Track your spread position daily.  Patience is the rule with spreads.  But you don’t want to forget that you have to be prepared to limit your losses as well.  The best way to do this is to track the progress of your trade in the daily newspaper or obtain a daily quote from your broker.  Spread profits – like outright position profits – can appear and disappear rapidly.  So try to stay on top of your position.

Play the probabilities.  Spread trading – especially seasonal spread trading – can have excellent percentage returns over time.  But this does not mean that every spread will prove a winner.  For this reason, risk only a small portion of your trading capital on any one spread.  You can afford to lose some of your trading capital in small portions – chances are the next trade will help you replenish your capital – but if you lose too much on one or two trades, you’ll be out of the game for certain.  Moreover, no one can tell in advance just what plays will prove profitable.  Futures trading is a game of probabilities and this is true where spreads are involved.

Trade the seasonals.  There are many, many seasonal trades, even in the markets that are not agricultural in nature.  This type of seasonal trading is nothing more than a probability play.  As with any trading strategy, of course, you must use sound trading judgment and employ the use of stops and other methods to cut short losses.  While there are never any guarantees in futures trading, you want to research the markets you trade and use the best available information to make a reasonable analysis of any given market situation.