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What are Commodity Spreads? Commodity spreads ( or straddles) measure the price difference between two different contracts, usually futures contracts. Spreads can also measure the difference between a cash contract and a futures contract ( referred to as the basis) or the price difference between two option contracts, or various combinations of the above. Background Investors generally look to diversify among a number of different markets in order to offset risk. However, traditional trend following programs, while producing adequate long term results, have generated below average returns in recent years. Typical spread trading programs use seasonal patterns which are both well known and unpredictable, producing unstable high risk returns. In recent years, the emergence of large amounts of money in the "long only" commodity fund has had a profound impact on the market. This program has been designed and tested by an experienced trader and finds a unique very profitable method of exploiting the large price movements resulting from rolls from one month to another in these long only funds. How the program works The program enters spreads between different contract months in the same market. The spread trade is entered several months from expiration and always exits at least one month before expiration of the nearby contract. By exiting the trade before the last month of trading, the spread avoids the very dangerous moves that spreads often make just before expiration. The markets traded in this program are: - Energies: Crude Oil, Heating Oil, Natural Gas - Grains: Corn, wheat, Soybeans - Metals: Silver - Meats: Live Cattle, Lean Hogs - Soft’s: Sugar, Coffee This program is executed by a professional trader with the average trade length being 1-2 months. Tight stops are used on a close only basis in an attempt to prevent large losses. Spread trading has many advantages as detailed below 1. Spreads act like a true market with consistent trends and predictable behavior. As most experienced traders know, when too many people jump into the same strategy, it eventually stops working. In the early days of trend following, traders made huge profits on trends that seemed to last forever. However, in recent years since tens of billions of dollars began chasing these trends, the success of this type of strategy has dropped dramatically and major draw downs have begun to occur. Many spread strategies are currently not overused and still hold the potential for tremendous rewards for those using the right approach. 2. Lower Margin -- Margins on spread trading can be very low and can allow the trader to produce a much higher return on their margin. 3. Many spread markets to choose from -- There are many times more spreads to trade then commodities. There are hundreds if not thousands of spreads that can be traded. This allows the trader to pick the exact market conditions he requires to enter a trade. 4. Diversification -- While many commodities are highly correlated spreads often trade in a unique way that is unrelated to other markets. This allows for substantial diversification over standard trend following approaches. 5. Less Risk -- Spreads are generally considered less risky than outright futures positions. Who are the participants In the financial markets, spread trading is active and often dominated by banks and large hedge funds. However, in commodities, the active participants have traditionally been floor traders and or seasonal traders. Floor traders are exchange members who execute transactions from the floor of the exchange exclusively for their own account. Seasonal Traders use history to figure out what time of the year they should enter and exit spread trades. Although seasonal spread trading has been well known and popular for decades, it has rarely worked successfully in recent years.
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