Spreads

A spread involves two transactions that simultaneously take one long position (buying) and one short position (selling) on two different contracts. Gains occur with a positive price change in one position more than offsetting a negative price change in the other. In rare situations, both “legs” of the spread may simultaneously be reflecting a gain.

• long position is position resulting from ownership of an asset
• short position is a position resulting from selling an asset that is not owned. There is a future obligation to repurchase.
• leg refers to on part of the the spread position, either long or short. Spreads are initiated and offset as a package, but alternatively can be “legged”. This means that the long or short position is initiated (or offset) independently of the other contract. This introduces additional risk and is typically avoided.

Futures Spread

A futures spread simply refers to the difference in value between two futures contracts. There are two basic types:

• Intra-market spread
  An intra-market spread reflects the difference in value between two contracts of different expiration months within the same commodity. As an example, if July corn futures are trading at $3.75 per bushel and September corn futures are trading at $3.85 per bushel, the spread between July and September futures is equal to 10 cents (September over July).
• Inter-market spread
  An inter-market spread reflects the difference in value between two contracts of different commodities. As another example, if Chicago July wheat futures are trading at $5.25 per bushel and Kansas City July wheat futures are trading at $5.75 per bushel, the spread between the Chicago and Kansas City July contracts is equal to 50 cents (Kansas City over Chicago). Here, even though we are comparing two wheat contracts, they are different markets and hence an inter-market spread. We could also compare the difference in value between two totally different markets such as wheat vs. corn, which would be an example of another type of inter-market spread.

Futures Spread to Manage Basis Risk

In managing the risk of an adverse change in cash prices, there are essentially two risks exposed to this change in price. A cash price consists of both a futures component or benchmark price, as well as a basis differential that relates that futures value or benchmark to a local cash market in which the commodity will be priced. By definition:

• cash = futures + basis
• basis = cash – futures

Often, futures are used as a hedge against an adverse move in cash prices. If futures are priced as a substitute to a cash purchase or sale, then this element of price is covered or hedged; however, the basis differential remains a floating variable to the final determinant price and is itself exposed to adverse variation in its value between the time the futures are hedged and the time the hedge is removed and the cash price is set in the local market.

• As a long hedger (someone who is short the physical commodity in the cash market), one is exposed to a stronger basis
• As a short hedger (someone who is long the physical commodity in the cash market), one is exposed to a weaker basis

As an alternative to forward pricing basis, futures spreads can be used to hedge the basis element of a cash price. The reasoning behind this is that basis and spreads tend to move together. For example, in situations where the cash market is very strong, basis tends to be increasing. This typically is reflected in the spot futures contract gaining relative to deferred contracts. In the opposite case where the cash market is very weak, basis tends to be decreasing and this usually corresponds with spot futures declining relative to deferred contracts.

• bull spreads are used to hedge against the risk of a stronger basis
• bear spreads are used to hedge against the risk of a weaker basis

Bull Spread

A bull spread is a position that includes an order to buy a nearby futures contract and sell a deferred futures contract. A bull spread can gain in value when nearby futures are increasing at a faster rate or decreasing at a slower rate relative as compared to deferred futures. Bull spreads are commonly used to assist in managing the risk of a strengthening basis – ahead of actually buying the basis with a supplier.

Bear Spread

A bear spread is a position that includes an order to sell a nearby futures contract and buy a deferred futures contract. A bear spread can gain in value when nearby futures are decreasing at a faster rate or increasing at a slower rate relative to deferred futures. Bear spreads are commonly used to assist in managing the risk of a weakening basis – after buying the basis with a supplier.