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Introduction to the Spread Market

The Concept of Spreading

The purchase or sale of a futures contract is considered to be an outright long or short position. Another strategy known as spread trading is also available to the hedger and speculator. Spread trading involves the simultaneous purchase of one commodity contract against the sale of another related contract. Natural spread opportunities are available in the energy market between different months of the same commodity contract, as well as between different products and grades. Some players confine themselves to trading outright futures and options contracts, leaving the enormous potential of the spread markets untapped. This is primarily due to the misconception that spreads are inherently more complex than outright positions. While there can be additional risk holding both long and short positions in different commodity contracts, it is generally accepted that having a position offset by an equal but opposite position in another commodity contract should lessen one's risk. This is reflected by the fact that spread positions are less costly to margin than outright positions. The hedger can benefit from the spread market as well. If spread values are closely monitored, they can provide valuable information as to when and where a hedge should be placed.

Types of Spreads

There are four basic types of spreads. Though the most commonly traded is the intramarket spread, they are all consistently played in the oil market.

Intramarket Spreads

This spread consists of a long position in one contract month against a short position in another contract month in the same commodity. Whether or not a trader is buying or selling a spread is determined by the exchange on which the contracts are traded. For an intramarket spread in the oil markets on the NYMEX Division of CME Group, if a trader is buying the nearby contract month and selling the more deferred contract month, they are said to be buying the spread. Conversely, if a trader is selling the more nearby contract month and buying a more deferred contract month, they are selling the spread.

For example: Buy April Crude Oil - Sell May Crude Oil on the NYMEX. In this example, the trader would be buying the spread since they are buying the more nearby contract.

The Intercontinental Exchange (ICE) also trades European based and other energy contracts. Three of the more active energy contracts traded on the ICE are the London Brent Crude Oil contract, the London Gas Oil contract as well as a financially settled crude oil contract based on NYMEX pricing.  The rules for buying and selling intramarket spreads on the ICE are also based on whether or not a trader is buying or selling a more nearby contract.

For example: Buy July Gas Oil and Sell August Gas Oil would be buying the July/August spread.

For example: Sell August Brent Crude Oil and Buy September Brent Crude Oil would be selling the spread.

Intermarket Spreads

These spreads feature similar or related commodities on different exchanges.

For example: Buy April IPE Gas oil and Sell April NYMEX Ultra Low Sulfur Diesel (HO) or 

Buy April IPE Brent -- Sell April NYMEX Crude oil

Intercommodity Spreads

These spreads are comprised of a long position in one commodity, and a short position in a different but economically related commodity.

For example: Buy April Gasoline -- Sell April Ultra Low Sulfur Diesel (HO)

Commodity-Product Spreads

This can be defined as the purchase of a commodity against the sale of an equivalent amount of the product derived from it (or vice versa). In the oil market, this is referred to as a "crack spread."  For a crack spread, if a trader is buying the product(s) and selling the crude oil, they are said to be buying the crack spread. Conversely, if a trader is selling the product(s) and buying the crude oil, they are selling the crack spread.

A crack spread represents a refiner profit margin. There are various ratios of crude oil to petroleum products that are traded by refiners. A 5-3-2 ratio closely resembles refiner activity in which 5 barrels of crude oil will yield approximately 3 barrels of gasoline and 2 barrels of heating oil (distillate).  Other ratios are 3-2-1 and 2-1-1 crack spreads. In 5-3-2, 3-2-1, and 2-1-1 spreads, the number of crude oil contracts traded is equal to the total number of refined product contracts traded. Since gasoline is a lighter product than a distillate, a barrel of crude oil will yield more gasoline than distillate.  Although these ratios are used, many refiners use a simple one to one ratio of a barrel of crude oil to its refined product. A one to one ratio may correlate well to their physical refiner margins and these one to one ratios are traded as a quoted spread on the NYMEX.

Selling 5-3-2 spread example: Buy 5 September Crude Oil – Sell 3 September Gasoline + and Sell 2 September Ultra Low Sulfur Diesel

A refiner may be shutting down their operations for routine maintenance. They have obligations to meet where they still have to buy physical crude oil and sell refined products. They will have to sell crude oil on the spot market since they may not have sufficient storage for their physical crude oil purchases. The refiner also has to buy gasoline on the spot market to meet its obligations to sell gasoline to marketers. As a result, the refiner may buy the crack spread to hedge their price exposure. Often referred to as a “reverse crack spread”, this consists of buying a refined product and selling crude oil. The refiner decides to hedge their exposure by purchasing one Gasoline contract for every Crude Oil contract sold.

For example: Buy 10 August Gasoline contracts and sell 10 August Crude Oil contracts.

Spreading in Theory

A spread transaction is established in expectation that the differential between contacts will widen or narrow. Each side of the spread is referred to as a "leg." If a trader is bullish for oil prices in general, they may anticipate that more nearby contract will lead or outpace the more deferred months as prices rise. If a trader is bearish for oil prices, they may anticipate that the more nearby months will lead or outpace the deferred months as prices decline.

For example: Assume November Crude oil is trading at $44.00, and December Crude oil is at $44.60. The trader buys the nearby leg - November, in the belief that the .60 cent spread will narrow (while simultaneously selling the November) because they expect the November contract to increase more in price than the December contract. 

As the market gains in strength, November moves to $48.00, and December to $48.10. To calculate the profit or loss, simply examine the profit or loss on each leg, and then the net result. In this example, the trader has lost $3.50 on the short December leg- but has made $4.00 on the long November leg. The result is a .50 net profit. Stated another way, the spread has narrowed from .60 cents to a .10 differential. It is important to note that the movement of the spread value is dependent upon the movement of the individual legs.

Spreading in Practice

Spread orders are normally placed by specifying the amount of difference between the two contracts of the spread, not the price level of each contract. Without this latitude spread orders would be impossible to fill because of the unlikelihood that both contracts would be at those exact prices at the same moment. The two most common types of spread orders are "market" and "limit." The market order would be the logical choice when spread values are unwavering and prompt execution is desired. If spread values are volatile, specific limits on the differential should be stated. The simplest type of spread order to execute is the one between two months of the same commodity. In this case, values are easy to determine because they are quoted on the same electronic exchange, much like an outright contract. Spreads between different commodities or exchanges are usually more difficult to execute. It should be noted that it is rarely advisable to place or liquidate spreads one side at a time. This practice of "legging" spreads can quickly turn a profitable trade into a loser. One should also avoid playing spreads involving the nearest expiring contract unless there is substantial liquidity remaining. A lack of liquidity can increase the potential for loss, as it may mitigate or exaggerate spread differentials. To determine the liquidity of a contract, simply compare the open interest to that of the other contracts.

Basic Spread Strategies

A trader uses the same skills to determine the potential of a spread as they would an outright position. Both technical and fundamental factors may influence their decision to buy or sell a spread. Consequently, the technical relationship between potential contracts are weighed along with the effects of supply and demand. There is no general rule that says that a spread will offer greater profit potential than an outright position, nor will it always be less risky. However, careful development of spread techniques can often translate into large profits.

Carrying Charge Strategies

Since oil is a non-perishable commodity, the maximum premium that the distant months may sell over the nearby month for a prolonged period is limited to the cost of carry. If full carrying costs are evident, very little risk, other than that created by changes in interest rates, is involved if your company buys the spread (long the nearby - short the differed, in an ascending market). Widening of the spread, which would create losses, is limited, while there is no limit to the amount that the nearby can run over the backs. In a carrying charge market, selling the nearby month and buying the distant, is usually not desirable. In that instance, the profit would be limited to full carrying charges, and the loss could be unlimited.

Inverted Market Strategies

The fact that the oil markets can be inverted (with the nearby month at a premium to the distant months) presents interesting challenges to the spread trader. It is still possible to profit if changes in differentials can be predicted. In a discount or inverted market, if one expects the discount to become smaller, the trader must sell the nearer and buy the distant contract. In order to profit when the discounts on the far months are expected to increase, one must buy the front and sell the back.

A Final Word

There are several books available concerning the various aspects of spread trading. The Rafferty Commodities Group encourages further study of the technical and fundamental considerations that influence the spread market. The Rafferty Commodities Group can provide your company with the technical support needed to help you forecast future spread market trends. Additional information on spreads is available upon request.

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