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What is Spread Trading?
Next to options trading, spread trading can be one of the most potentially confusing areas of finance. However, the essence of it is fairly simple. Spread trading means buying a futures contract or other type of security and selling another related one in order to profit from the price difference, or “spread” between the two. This is often done to take advantage of predictable seasonal changes in the price of certain commodities. Investors who use the spread trading technique may study historical or technical factors in determining when and how to place trades and where prices are likely to go.
Spread trading falls into three basic categories, the first one being intramarket spreads. This is the simplest type of spread trade and involves buying and selling the same commodity, but for different months. For example, an investor might buy July wheat and sell December wheat. Intermarket spreads are a second type in which different commodities are traded for the same month. An example of this might be buying July wheat and selling July corn. The third type is the inter-exchange spread, where one commodity is traded but on two separate exchanges. For example, an investor might buy July wheat on the Chicago Board of Trade (CBOT), but sell October wheat on the Kansas City Board of Trade (KCBOT). Inter-exchange spreads are less commonly used than the other two types.
There are many commonly used patterns in spread trading, many of them with nicknames that suggest the commodities involved. For example, a Spark spread is a spread trade between natural gas and electricity, and a Crush spread is a spread between soybeans and soybean meal and/or soybean oil. In any spread trade, an investor or trader must concern themselves with whether or not both sets of prices are moving in their favor. The amount of attention and expertise this requires can make these trades somewhat confusing, especially to an inexperienced trader.
Most securities exchanges do not report spread transactions along with other price quotes, although this practice was once common. To get accurate data on current spread trading, it is helpful to have the assistance of a broker who can contact the trading floor for the latest information. Spread trading can have value for some investors, but the cost of working closely with a broker may be prohibitive for some. This factor, as well as all the costs of spread trading, must carefully be considered by the individual investor.
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![Investors who use spread trading may study historical or technical factors in determining where prices are likely to go.]()
By: leungchopanInvestors who use spread trading may study historical or technical factors in determining where prices are likely to go.
Discussion Comments
Commodities trading has always confused me. It seems like it is taking a real thing with a very real value and then just abstracting it until no one really knows what it is worth or why.
I know that this is how most financial mechanisms work. They don't have much basis in the real world, they are just trick that people play with money so that they can make more money. But this kind of behavior seems so much less acceptable in the commodities market than on the S&P or the Nasdaq.
I have been a commodities trader for years and I remember a terrible story about spread trading from when I first got into the business. I worked for a large firm who I will not name here. We had a junior vice president that was know for making risky investments. This cause a lot of crumbling but they frequently made a lot of money and he was considered a rising star in the company. One day, without going through the proper channels or clearing it with those above him he made a huge bet on an inter-exchange spread.
You probably know where this story is going. The investment didn't pay off and the firm lost a ton of money, multiple millions of dollars. There was hell to pay to say the least. The mood in the office that day was kind of like a funeral. People didn't speak much and avoided eye contact. The VP ended up getting fired and last I heard he had never returned to commodities trading.
I have seen these kind of bets pay off and even been a part of a few really successful spreads myself but they take a lot of time, homework and luck. It is not something you can just go out and do, you have to be really certain you have made a good bet and even then there is a lot that can go wrong. I learned a lot from that silly VPs mistake. You can't make risky bets with other people money.
Just like the article says, spread trading is confusing, even when you have a nice explanation to read through. Luckily I have never needed to get this deep into finance. I have a few investments, but they mostly just sit there earning modest return while I wait to retire. I can understand why there are these complicated and confusing financial maneuvers but I am glad I don;t need to get involved with them. When it comes to money transparency is key. The more you know, the more you understand, the safer your investments are.
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