Commodity Trading Strategies - The Spread
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by: amaramar
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Many of the more common commodity trading strategies actually serve two purposes. The turn of a profit is but one. A hedge is the other purpose. Hedging is a method of minimizing risks by attempting to purchase some form of insurance. As well as minimizing risks, it also usually caps potential profits. One of the strategies to accomplish this is known as the spread.
The majority of the commodities trades do not involve trading the commodity directly, but more in buying or selling a futures contract. "Going long" and "going short" are two of the most basic strategies
To go long means to purchase a futures contract while anticipating that the price will rise before the contract expires. Futures contracts are very similar to stocks or options because vary rarely do the traders or specialists have any actual contact or participation with trading the commodity itself.
Conversely, to go short means to sell the contract while anticipating that the price will drop before the contract expires. Many novices are often perplexed by this strategy. The have trouble wrapping their mind around the concept that the contract is sold by the trader before they even own it.
While the notion may be confusing, the practice is quite simple. While the technicalities remain unseen by the traders, the inner workings are rather simple. The contract is borrowed and the one is bought to make of the shortfall later.
An illustration of this concept is as follows: Trader X sells a futures contract in May for September wheat for $6.00 per bushel. The contract will be written for a minimum amount, which is typically around 5,000 bushels. The price falls in August to $5.40 per bushel. This will yield a profit of 60 cents on each bushel, which equals $3,000, excluding commission. The profits and losses for these ventures are settled daily for trading accounts and the broker balances the books by buying a contract of the same type on the trader's behalf with the trader's money.
Effective trading strategies are a combination or different types and lengths of contracts. Throwing in some form of spread is one of the simplest. There are a number of varieties that can be executed, but a simpler approach is sometimes the best move.
An example of this more simple approach is illustrated in this hypothetical situation. In May, the price for a July wheat contract is $5.90 per bushel and for a September contract the price is $6.00 per bushel. By predicting the spread between these two and by anticipating changes before July to greater than 10 cents - and to be correct in that prediction could yield a profit by selling the July and purchasing the September. By shorting July and going long in September, you do profit.
This profit is incurred by watching carefully the behavior of the contracts and acting accordingly. In June, the July contract may have risen to $6.00 per bushel and the September to $6.25 per bushel. By liquidating both positions, in other words, settling both contracts, this results in a 10 cent loss on the July contract, but a gain of 25 cents on the September contract. This means a 15 cent profit per bushel. A small commission will be incurred on the turn around, but it is minute. On a contract that covers 5,000 bushels, this means a net gain of $750.
While a larger gain would have resulted had July not been shorted, but all trading carries risks and it is impossible to predict the future, especially in the stock market, with any degree of certainly. Hence, the term, speculation is used to refer to these activities.
There is an element of rationale for betting against yourself by shorting and by going long at once allows the trader to hedge their best on whichever direction they expect the market to take. Utilization of this spread strategy as well as with many other variations does succeed in capping the potential for profit. However, it does work to minimize downside losses as well.
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