Basics - The three basic types of spreads that can be performed in the futures markets are intracommodity spreads and intermarket spreads.
Probably the most common, intracommodity spreads (also known as intermonth spreads), refer to the simultaneous purchase and sale of different months of the same commodities. Strategies will vary from market to market, depending on the nature of the contract. Many commodities trade the back months at a premium to the front months, or vice versa. The latter is known as an intraverted market, or backwardation. Some traders use "inverted" to refer to a market trading in a manner opposite to its normal pattern, regardless of whether the from month is at a premium or a discount to the back months. Even in markets that have a fairly established pattern, these relationship sometimes will flip-flop due to seasonal changes or extreme market conditions.
Intercommodity spreads involve buying and selling separate but price-related contracts, such as T-bonds and T-notes or wheat and corn. Certain contracts, mostly those within a commodity group, historically have exhibited related price movements that make them attractive candidates from spreading. Wheat and corn might move in the same direction, but at different rates at different times.
One difficulty with this type of spread is a conflict in the size or denomination of contracts. You much then buy and sell different number of contracts to establish an equivalent money ratio for the spread.
Crush and crack spreads illustrate this phenomenon. With the crush spread, traders who feel soybeans are under priced compared to soybean meal and oil will buy the spread, buying 10 soybean contracts while selling 11 soybean meal and nine soybean oil contracts. Traders who feel beans are overpriced in relation to mean and oil would sell the beans and buy meal and oil in the same ratio. Soybean contract size is 5,000 bu., soybean meal is 100 tons and soybean oil is 60,000 lbs., so the ratio of the spread approximates an equal proportion of soybeans to what will be produced, meal and oil. The crack spread is a similar trade in the energy markets, where crude oil, gasoline and heating oil are spread in a 3-2-1 ratio.
Intermarket (or interexchange) spreading entails going long and short the same commodity in a different marketplace - CBOT wheat against MGE wheat, or New York vs. London coffee. This type of spreading is similar to the arbitrage trading performed int he financial markets, however traders might look for discrepancies in the price of a particular stock traded on two different exchanges. The trader buys the lower priced and sell the higher priced for an immediate profit. Opportunities like this are rate and short-lived, and usually require putting on extremely large positions to take advantage of the same price differentials.
Understanding spreading concepts and having a good idea of where different contracts should trade in relations to one another can still you if you simply want to put on an outright position. After you decide you want to go long a particular commodity, you still have to pick which month to buy. After performing some spread analysis, you might determine that December oats seem under priced in relation to September oats, and show greater bullish potential over the next few weeks. Rather than placing your order in the front month automatically, you could then place your buy order in December.
Downside - Despite their advantages, spreads are not without their drawbacks. Transaction costs, while still less expensive than putting on two outright positions, are greater than they are for single transactions. Intercommodity and intermarket spreads, depending on the relationship of the commodities and exchanges involved, may not have the same margin reductions available for intracommodity spreads.
Also, where low markets do exists, traders can be tempted to put on too many spread positions, thus exposing themselves to as much, if not more, risk than they would have they put on an outright position.
Also, if a market invests after a trader puts on spread, the basic price relationship he based his position on is gone, and he can face unlimited losses.
Another trap in the spread game is the practice of legging in and out of spreads. In most cases this is an unadvisable strategy. A good rule is not to put on a spread unless prices are already conducive to doing so. If you have to wait, don't. Buying or selling one-half of the spread outright and then waiting for a more favorable price in the other outright market leaves a trader open to the distinct possibility that the market will go against him before he can complete the spread. Furthermore, if the initial position was established in a back month with little liquidity, getting out could be a real nightmare.
