Using the Spread as a Commodity Trading Strategy

July 12, 2009 by  
Filed under Commodities Trading

Commodity trading can be extremely profitable or quite the opposite, depending upon the types of trading strategies employed. The highly volatile commodity markets require investors to carefully determine the best buying habits and speculations in order to profit from this type of investment.

Strategies are typically implemented in any investor’s or commodity broker’s daily trade habits in order to minimize risk or use them as a hedge. However, along with minimizing risk comes the possibility of lowered profits. The spread is one of the best ways to hedge risk and still realize profits as a popular investment strategy in commodities trading.

Usually, commodities trading requires you to buy or sell a futures contract, and you may simply employ the strategy of ‘going long’ or ‘going short’ in this process.

‘Going long’ means that you are purchasing a futures contract, speculating that the price of your chosen commodity will rise prior to the expiration date. These contracts are bought and sold just like stocks and options.

‘Going short’ means just the opposite. Here, you will sell a futures contract to another investor, expecting the price will fall prior to the expiration date. This strategy requires a little more explanation, though – how do you sell these contracts when you don’t own them in the first place?

The answer lies with your commodity broker or online commodity trading account. Going short requires you to borrow the contract and buy one later to make up any shortfall (rise in price). Let’s look at a specific example:

In April, you sell a contract for August corn at $5 per bushel, and the contract is written for a minimum amount of units – typically 5,000 bushels for grains. If the price falls in July to $3 per bushel, you’ve just profited $10,000 before paying the required commissions.

Commodity trading strategies usually involve selling various types and lengths of contracts for the goods, and the simplest type is the ‘spread’. Here, we’ll discuss an easy-to-understand example:

In April, the price for a June contract for corn is $6 per bushel and the same contract for August is $6.50. If you predict the ‘spread’, or price difference between the two, will change prior to the June expiration date more than 50 cents, you may profit this difference by selling the June contract and purchasing the August contract. This commodity trade is going short on June and long on August.

So, how do you profit from this type of spread trade? Let’s assume in May the June contract price rises to $6.10 and the August contract rises to $7. If you settle both contracts, you lose 10 cents a bushel on the June contract and gain 90 cents on the August contract. Though you lost on the June contract, you still made a net profit of 80 cents per bushel, which equals $4,000 for a standard unit of 5,000 bushels in this example.

Hedging your investments by going long and short at the same time can lower potential profits, but also reduce your possible losses over time.

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