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Trading Strategies - The Spread

A large number of common trading strategies are for the purpose not only of making a profit but, as a hedge. Hedging is essentially an attempt to buy some form of insurance to minimize risks. Typically, along with minimizing risks comes a cap on potential profits. Let's examine one of these strategies: the spread.

Most commodities trades are in the form of buying or selling a futures contract, not trading the commodity directly. The most basic strategies here are 'going long' or 'going short'.

Going long simply means buying a futures contract with the expectation that the price of the contract will rise before its expiration date. Futures contracts are bought and sold much like stock or options - only a small minority of specialists actually have anything to do with trading the actual commodity.

Going short is the flip side - selling a contract with the expectation that price will decline before expiration. Going short is often seen by novices as puzzling and even paradoxical. How do you sell something you don't own BEFORE you've bought it?

Puzzling in theory, simple in practice. The mechanics are hidden from traders, but in essence speculators borrow the contract, then buy one to make up the shortfall later.

Suppose you sell a futures contract in May for September wheat for $6.00 per bushel. The contract will be written for at least a minimum amount, typically 5,000 bushels. Now suppose the price does in fact fall in August to $5.40 per bushel. You've made a profit of 60 cents on each bushel. That's $3,000, excluding commission. Though profits and losses are settled for trading accounts daily, the books ultimately get balanced by the broker buying a contract of the same type on your behalf. With your money, of course.

Trading strategies involve mixing the types and lengths of contracts. One of the simplest is some kind of 'spread'. There are several varieties, but take a simple example.

Assume it's May and the price for a July wheat contract is $5.90 per bushel and for a September contract the price is $6.00 per bushel. Suppose you predict the price difference ('the spread') between the two will change before July to greater than 10 cents. If you turn out to be right, you could profit by selling the July (today) and buying the September (today). You short July and go long on September. How do you profit?

Suppose that (in June, say) the July contract has risen to $6.00 per bushel and the September to $6.25 per bushel. You 'liquidate both positions' (settle both contracts). What are the results? You lost 10 cents on the July contract (ouch, can't be right every time), but you gained 25 cents on September. You pocket 15 cents per bushel (minus a small commission on the 'turn around'.) Since each contract covers 5,000 bushels your net gain is $750.

Naturally, you would have made even more had you NOT shorted July in the first place. But it's impossible to predict the future with certainty. That's why they call it speculation.

The motivation for 'betting against yourself' by shorting and going long at the same time is to hedge your bets on which way the market will in fact go in the future. This spread strategy (along with dozens of other variations) does cap the profit potential, but it helps minimize downside losses.