Spread trading is combination of a long and a short position at the same time in related futures contracts or options, called legs. Aim of Spread Trading is to gain profit from the widening or narrowing of the spread between two related futures contracts or options. Similarly, a commodity spread trading is a strategy of simultaneous purchase and sale of the same or a similar commodity. These positions may be on the same exchange or on different exchanges and in the same maturity contract or different maturity contracts. For example, buying & selling Lead and Zinc futures contracts respectively at the same on the expectation that there spread will narrow down in the future.
A Spread Trading in the same commodity known as Intracommodity whereas in different commodities known as Intercommodity. In the same way, it can be Intramarket (positions on the same exchange) or Intermarket (positions on different exchanges). It can be Intradelivery (contracts mature in the same delivery month) or Interdelivery (contracts mature in different delivery months).
In this section, we will focus on Intercommodity spread & try to understand the same with the help of Zinc & Lead. Below mentioned chart represents the price and spread of Zinc & Lead from past few years:
From the above chart, it’s clear that Lead & Zinc price are almost equal from past few years and whenever there is spread between them, the prices converge and the spread tend towards zero.Although, the spread which has been created from the month of Feb-2016 is not covered yet, but still we can comfortably say that Lead & Zinc price have tendency to move in tandem.
Now look at the below mentioned table to get an idea as to how we can use the above mentioned behavior of lead and zinc for profitable spread trading:
From the above table, we can interpret that spread between Lead and Zinc reached to higher levels (above the normal average) in the month of Jan-2011 which is almost 11 points. This higher value of spread was basically due to higher increase in price of Lead as compared to Zinc. In this case we can go for intercommodity spread trading b/w Lead and Zinc by selling Lead & buying Zinc simultaneously on the same exchange. Later on, we can see that the spread is reduced and reached to almost 3 points in the month of Feb-2011 and provided a gain of 8 points.
If we are expecting that the spread will narrow, we have to sell the commodity leading in the movement (in above example Lead) and have to buy the commodity lagging in the movement (in above example Zinc). If we are expecting further widening in the spread, then we have to go for vice-versa.
At the time of entering into spread, we have to set Target & Stop Loss (SL) in terms of spread point. In case we are expecting that spread will narrow, we have to set target (in terms of spread points) below the current spread and SL (in terms of spread points) above current spread by managing the proper risk reward ratio, preferable 1:1.5
Spread trading is a profitable tool if used with proper analysis and following the disciplines of trading. The expectation of always generating profit from spread trading is not possible but if used with proper risk reward management, the probability of odds in favor is always higher.