ASX Charting Course

Chapter 31

Spread Charts

Futures contracts have fixed expiration dates that generally occur in the months March, June, September and December. Some commodities have a contract for every month, while others are more influenced by seasonal factors.

A spread chart is constructed by subtracting the price of one contract from another contract. Normally it will be the result of subtracting the near contract form the far, the old from the new. This yields a line chart that can be analysed by applying classic techniques.

Futures markets can be extremely volatile and are fraught with risk. One way to reduce or manage risk is to use spreads as a trading vehicle, rather than taking an open futures position. This reduces the risk of ruin considerably, which is of course open ended with a futures contract. A spread trade is achieved by buying or selling a commodity contract in one month and doing the opposite in another month.

If the future months are continuously priced lower than the front month, the market is said to be in backwardation.

Conversely if the distant months are progressively higher priced, relative to the front month, the market is said to be in contango.

There are a lot of factors that will determine the future price of a commodity. The premium built into the futures contract price is based on a calculation called the cost of carry. The cost of carry is the cost of holding a particular amount of a physical commodity, the cost of capital and the cost of whare housing, storage. This cost is priced into a future month contract, generally based on a premium to the front month. The other dominant pricing factor is market sentiment. A bullish sentiment builds a premium in, while a bearish sentiment will reflect as a discount.

If the market sentiment is bullish and the market is in contango, as we would expect, the spread should continue to increase or widen. To take advantage of the increasing difference in price between the two contracts one could sell the near month and buying the far month. This is referred to as a negative spread adopting the position of the front month leg.

If market sentiment is bearish and the market is in backwardation the spread should be increasing in size, but in the opposite direction to the example above. In this case, even though the difference maybe getting larger the actual measure is a negative number. To take advantage of this sort of move one is required to buy the near month contract and sell the distant month contract. This is called a positive spread.

This positive and negative spread, as a type of trading position, should not be confused with the actual price of the spread being positive or negative. However whether the price of the spread is positive or negative, above or below the 0 line, will more than likely reflect the long term trend outlook to some extent. A long term bull market will probably be in contango, while a long term bear market will generally be in backwardation. Therefore when the trend changes there is a chance that the price of the spread could swing from one side of the zero line to the other, negative to positive or vice versa. Even so that movement is still likely to be less in absolute terms of risk than the movement in the underlying commodity.

Exchanges generally discount the initial margin levied on spread contracts. They recognise the reduced risk represented by a spread position. In a big move in the underlying futures contract the spread movement may be merely insignificant.

The example below is derived from the two different month’s contracts below. The front month is priced at 9440 and the back month at 9431. The price of the spread is therefore 9440 - 9431 = 9. That has come from a low at -3 to a peak at 11 just recently and it looks like it has been trending. During this widening of the spread the market has been in a bear market trend and the market is therefore said to be a bear market in backwardation. The continuation of that bear market in the underlying commodity suggests continuation of the current trend in the spread. A change in trend should be reflected in both the commodity and the spread.

Fig 41 © Copyright 2003 CQG, Inc. All rights reserved worldwide

Fig 42 © Copyright 2003 CQG, Inc. All rights reserved worldwide

Fig 43 © Copyright 2003 CQG, Inc. All rights reserved worldwide