I’d like to introduce you to a more sophisticated method of trading--spread trading, a technique that fits well into the game plan of many professionals.

I know some traders who trade spreads exclusively because they feel it’s the best way to limit certain risks inherent in futures and options. Below, I describe an excellent spread opportunity for the new year.

When you enter a spread, the objective isn’t necessarily to make money on a rise or fall in the market in question; the goal, rather, is to profit on a change in the relationship between different prices. When you enter a spread, you buy one contract while simultaneously selling another. You’re long and short in either two related commodities or two different months of the same commodity at the same time. The relative changes between the two will determine your profit or loss.

There are two major categories of spreads, intramarket and intermarket.

Intramarket spreads consist of buying one month in a particular commodity and simultaneously selling a different month in the same commodity. Two examples are buying March crude oil and selling April crude oil, or buying May cotton and selling December cotton. You’re trading two different months in the same commodity--one long and the other short--and their respective prices will tend move in the same direction.

So how can you possibly make money in a spread? While they may tend to move in the same direction, they don’t have to, and even when the two months move in the same direction, they generally tend to move at different speeds. Many times you gain on one side of a spread and you lose on the other, but what you’re looking for is a bigger gain on the winning side than the loss on the losing side.

Let’s look at an example. Assume you established a spread between March 2007 copper and July 2007 copper in December 2006. You’re buying the March and selling the July. When you buy the near month and sell the distant, it’s called a bull spread. A bear spread (short March, long July) is the mirror image. When you enter a bull spread, you’d like to see the near month either rise faster than the distant or fall slower. Either outcome will be profitable.

Spreads can be more predictable at times than outright positions--which is precisely the reason many traders like them. There are no sure things when trading, but spreads can often put the probabilities in your favor.

Look at this particular example. Historically, the March copper has gained the majority of years on the July because of seasonal considerations. March is historically a high-demand time of the year for copper because of inventory rebuilding prior to the peak building season. Suppose March is trading at 302 and July is trading at 301 when you put on the spread in December. You have put on this bull spread--long the March, short the July--with the March trading at a 100-point (1 cent per pound) premium to the July. (If the March was trading at 300 and the July at 302, you’d say you were long the March and short the July, with the March 200 points discount to the July.)

A few months pass, and in February, copper has risen in price with both months appreciating--but at different speeds. The March is trading at 315 and the July at 310. The spread has now widened from 100 points premium the March to 500 points premium the March, and you sense it’s time to take your profits. You’d give your broker an order to do the reverse transaction--that is, sell the March and buy the July. This will offset both sides of the spread and effectively wipe your slate clean.

Let’s look at the result. The March has risen from 302 to 315, so you have a 13-cent (or 1,300-point) profit on this side of the spread. The July, the short side, has risen from 301 to 310, so you have a 9-cent (or 900-point) loss on this side of the spread. The difference between what you gained and what you lost, 1,300 minus 900, is your profit--in this case, 400 points. Note that you don’t need to calculate both sides to determine your profit; this works out neatly to be the spread differences, 500 minus 100 equals 400. Because 1 point in COMEX copper is worth $2.50 per contract, this is a gross profit (in other words, we’re not taking commissions into consideration here) of $1,000 per spread.

The question arises, why trade the spread when you could have made more money by simply buying the March outright? In this example, March rallied from 302 to 315, a 1,300-point move, or $3,250 profit versus $1,000 for the spread. It all has to do with the risks versus the reward. Spreads generally move slower. Yes, you can just as easily lose in a spread, but at times, you can gain even if the market didn’t move the way you’d planned.

What if the economy weakened and March copper fell 1,300 points? If you were long, you would have lost $3,250 per contract. The spread could certainly fall 400 points, but it’s also possible traders would turn bearish on the whole market and both months could go down the same amount, therefore resulting in no loss. When spread trading, you’re more interested in the difference between the months than the outright flat price movements.

The ability to profit in both up and down situations is one of the advantages of spread trading. Also, the margin requirements for spreads are generally much smaller than outright positions because the exchanges recognize that in most cases spreads are less risky. You’re somewhat insulated from dramatic news with the resulting price shocks when spread trading. Additionally, as I mentioned above, spreads tend to move slower, giving you more time to react. And many traders believe spreads are more predictable.

Intermarket spreads consist of buying one commodity and simultaneously selling a different but (usually) related commodity. Examples would be buying silver and selling gold, or buying Minneapolis wheat and selling Chicago wheat (a spread we traded a number of times in 2006). In these examples, the two markets are related and they generally move in the same direction because the same market forces affect both. However, they’ll move at different speeds.

For example, you may decide to buy July corn and sell July wheat. Both are grains, they can both be used for animal feed, and both are export commodities. But one is used for ethanol production, the other isn’t, so you may believe corn will gain at a quicker pace than wheat in a bullish grain environment.

The spread I want to bring to your attention is an intramarket spread in the corn market. It involves buying July corn and selling December corn. A statistic I recently saw is leading me to believe this spread could have some dramatic profit potential and a favorable reward-to-risk ratio. Before I get into this, let me show you what this spread did once upon a time.

In January 1996, December 1996 corn futures were trading at about $2.90 per bushel. By July of that year, December futures had rallied to nearly $3.90--100 cents (each cent equals plus or minus $50 per contract traded) or just about a $5,000 profit per contract traded. This resulted in a more than 500 percent return in less than six months--not bad for a margin deposit of only about $1,000.

December 1996 Corn



Source: Commodity.com

However, if you had played the spread of long July versus short December during this time period, you’d have done even better.

Here’s how the chart of the spread looked that year:

July 1996-December 1996 Corn Spread



Source: Commodity.com

The price (vertical column) represents the spread difference, or July 1996 corn minus December 1996 corn. When the year began, the spread was trading at about July 60 cents over December and at the peak reached 180 cents July over. (How did the spread move from 60 to 180 while the December corn ran up 100 cents? The July corn in December was trading at $3.50 and moved up to $5.50, a gain of 200 cents during the period the December ran up from $3.00 to $3.80 for a gain of 80 cents; 200 minus 80 equals plus 120.)

The 120-cent gain represents $6,000 per spread traded, but as a percentage on margin, it was more than four times greater than trading the December contract outright, because the margin requirement on this spread was only $250 for each spread versus $1,000 per contract.

What happened in 1996 was the perfect storm for the July/December corn spread. There was a shortage of old-crop (July) corn, and the market was afraid the US would run out of corn before the new crop (December) became available. At the same time, the new crop December corn developed into a large crop and replenished the depleted supply.

I’m not suggesting the July/December corn spread will do in 2007 what it did in 1996. But it has profit potential; this takes us back to the statistic I referred to earlier.

The situation is different this year. There’s no corn shortage, there was a big crop last year, and at this time, we know absolutely nothing about the new crop because it hasn’t even been planted yet. However, as you probably know, I’m bullish on corn because of the phenomenal demand that’s projected to hit this market in the coming year for ethanol production.

The statistic? Since this year’s harvest, farmers have socked away 600 million bushels into the government loan program. They’ll no doubt move more corn into this program after New Year's; perhaps 1 billion bushels of corn could be stored under loan next year. The loan program (where farmers receive a low-interest loan to store corn off the market) is designed to raise prices in times of low prices by reducing market-available supplies.

It’s unprecedented--and was surprising to me--to see this much corn placed in the program because prices are at 10-year highs. Farmers can get their corn back when they repay the loan with interest, but this is saying farmers are bullish on corn, just like I am. They're using the loan program to store their corn and as a cash flow generator. The net result could be a shortage of old-crop corn. And although it may be more of an artificial shortage, it’s nevertheless a shortage that could result in old-crop (July) corn gaining on the new crop (December).

Take a look at the chart below of the current July 2007/December 2007 corn spread.

July 2007-December 2007 Corn Spread



Source: Commodity.com

The July 2007/December 2007 spread peaked at about 38 cents July premium in November and has recently dropped to around 20 cents July premium. The correction in the spread appears to have run its course. I’d consider entering the spread in the current area, risking to 5 cents July over. As of this writing, this projects to be a risk of approximately $750 per spread plus fees.

What can we expect on the upside? It’s hard to say and depends how aggressive (or nervous) the corn buyers become in coming months. I don’t think a move to more than 50 cents premium July is at all unreasonable, for a profit potential of more than $1,500 per spread traded. The spread margin (subject to change) currently required is $250 per spread. Margin is like a good-faith deposit and is returned upon exiting the spread, plus any profits or minus any losses.

Although spreads can many times be less risky than outright positions, there’s still a high risk of potential losses in all futures trading; it’s not appropriate for all investors.

My final 2006 words of advice are these: Although all your trades won’t be profitable, to be a winner, all you need is for your profitable trades to be more profitable than your losers.

Finally, I’d like to wish you and yours a healthy and prosperous new year.

George Kleinman is editor of Commodities Trends.

© 2006 George Kleinman
Editorial Archive

Can July 2007 corn exceed the all-time high price of $5? Time will tell, but I've recommended that Futures Market Forecaster subscribers maintain their core positions in the corn market. And I'm in the process of identifying selective trades that will allow us to pyramid core corn positions (recommended for purchase last August) with a reasonable projected risk point.

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Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the "Holy Grail." Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.

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Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.