V.11:3 (133-139): Trading Spreads by Thomas Cronin

V.11:3 (133-139): Trading Spreads by Thomas Cronin
Item# \V11\C03\TRADING.PDF
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Trading Spreads by Thomas Cronin

The price relationship between delivery months of a futures contract or between different futures contracts often change. And of course, where there is change opportunity arises for traders. Here, STOCKS & COMMODITIES author and commodity trading advisor Thomas Cronin explains how to trade spreads.

Spreads, because of their lower margin requirements and in many cases lower risk, have always been popular and especially among grain and livestock traders. Although spreads are commonly used, few traders have even a basic understanding of the mechanics of spread trading. Even most commodity brokers tend to fumble their way through the placement of spread orders. So here are a few details involved in trading spreads as well as a seasonal spread as an example.

Basically, spread trading involves taking a long position in a futures contract while taking a short position in another futures contract at the same time, either in the same market or a related market. Similar to arbitrage, a spread trader attempts to take advantage of price differences between these two positions, betting that the difference will move in his or her favor. Generally, a spread trader is more concerned with price relationships than with price direction.

To understand spreads best, they are always written as follows: Buy or long side is first, sell or short side second and then the spread difference. A minus sign means the buy, (long) side is a discount, a plus sign means the buy, (long) side is at a premium. This way, you always want the spread difference to become more positive that is, a higher number. This helps immediately understand the current profit position in relation to the entry level. However, it is not necessarily the acceptable way used in trading or quoting spreads. Here are some standard practices on the exchange trading floors.

SPREAD QUOTES AND PLACING ORDERS

Grains/livestock: Generally, most grain and livestock spread orders are given buy side, then sell side with the premium stated either buy or sell. For example, if you wanted to execute a December/June live cattle spread at +$3.00, the order would read: buy one December cattle/sell one June cattle, 3.00 premium the buy side. If you wanted to execute an old crop (July)/ new crop (November) soybean spread at -0.04-1/2, the order would read: buy 5,000 bushels July/sell 5,000 bushels November soybeans, 4-1/2 cents premium the sell side (soybeans, corn, wheat and oats are quoted in 5,000 bushels). Most phone clerks on the trading floor are used to dealing this way; this order will accomplish what you intend to do in any kind of spread.




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