What is a spread in commodity markets?
Spread: Grasp the main features of this key indicator for commodity market traders.
In commodity markets, the term spread is commonly used as an indicator of the price difference between:
- The same asset traded on different dates (with different contracts)
- Different assets are traded, but they have some relationship with each other
- The same asset is traded on different exchanges.
For example, imagine that two different futures contracts for soybeans for October and November are traded on the Chicago Stock Exchange, and are quoted at US$15.00 and US$13.00 per bag, respectively. The spread between them will be US$+2.00/bag (15.00 – 13.00 = 2). If the price of the contract with the closest expiration is higher than that of the most distant, the spread between them will be positive, and vice versa.
In this text, you’ll come to understand the main concepts related to spreads. Keep reading to find out more!
What factors influence the spread?
The price spread contained in contracts for the same commodity is determined by several factors, such as supply and demand expectations, interest rates, and carrying costs.
The supply and demand situation for a specific commodity has a direct impact on spreads. If demand exceeds supply, short-term prices may be higher, leading to positive spreads. If supply surpasses demand, short-term prices may be lower, resulting in negative spreads.
In turn, higher interest rates in the short term tend to increase carrying costs. Thus, the prices of shorter contracts tend to suffer some devaluation while longer contracts tend to appreciate.
It’s very common for rural producers to analyze the price spread of their commodities over time to define the best time to sell. When they decide to postpone the sale, the carrying cost rises, which then entails some expense for storing the product.
There are two main factors that influence this analysis:
- The financial cost of postponing the sales receipt, and
- The operating cost of storing the asset, if producers prefer to carry their stock in the short term, betting on better sales conditions in the future.
Hence, to compensate for the future sale, the seller must receive a higher price, which will cover both the financial and carrying costs. When this total cost is positive, the market expects the future sales price of the commodity to be higher than on the spot market.
How does the spread curve work?
The spread curve reflects the differences between the traded value of a commodity’s futures contracts over time. Like the price curve, the normal spread curve (also called the carry curve) occurs when futures contracts increase in value over time, generating negative spreads.
This scenario is common in cases where assets available are adequate to meet demand, such as abundant grain harvests, during a period of stable demand. Therefore, maturities closer in time tend to be worth less than maturities in the future.
The inverted spread curve occurs when short-term demand is greater than supply, causing an increase in contract values in the short term. This scenario is unusual and typically lasts only for a short time.
There’s also something called the flat spread curve, which displays a low variation between contracts traded today and in the future. In effect, it signals that the market presents less volatility.
Strategies involving the spread: Understand the concept
The spread can be applied in various strategic ways for commodity market traders:
- Intra Commodity Spread / Calendar Spread
This spread uses futures contracts in situations where a trader buys/sells a commodity future that will expire on a certain expiration date and simultaneously sells/buys a future for the same underlying commodity expiring on a different date.
- Inter-Market Spread
The intra-commodity spread or calendar spread ensures simultaneous entry into long and short commodity positions, with the same underlying asset, but with different expiration dates.
The difference between commodity values with the same expiration month but on different exchanges can also be leveraged. It’s possible to open a position to buy soybeans on the B3 futures market while selling soybeans in a futures contract on the Chicago Stock Exchange, for example.
- Inter-Commodity Spread
This tool attempts to take advantage of the value differential between two or more related commodities, such as soybeans and soybean meal. The inter-commodity spread trader can go long on futures contracts during a particular expiration month, while also going short on a related commodity during the same period.
hEDGEpoint: Extensive knowledge of the entire commodities sector
Understanding the spread is clearly a complex subject. Knowing what this concept is and how it works can make all the difference in your business.
hEDGEpoint has a deep understanding of commodity markets and all their aspects. With a team that operates globally, we’re able to combine data analysis, multidisciplinary knowledge, and diverse insights to make more informed decisions.
Talk to a hEDGEpoint specialist today.
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