Chapter 8, spreads. This chapter will cover futures spreads where you buy one futures contract and sell another futures contract. In the options chapter, we'll look at option spreads where you buy and sell options. Chapter 8 is on futures spreads. When it comes to commodity spreads, there are different types of spreads that the test may throw at you. The first thing you have to know how to do is identify the different types of spreads. So let's take them one at a time. The first one, an intraarket or quite often called an interdely month spread. The first thing to note is the term intra means the same or within. So intraarket means the same market. So maybe that's the CME. Inter means between different. An interstate highway goes from state to state. So interd delivery month means different delivery months. So what is this spread? An intramarket or interd delivery month spread is the purchase and sale of the same commodity on the same exchange intraarket but different expiration months inter delivery. So an example of this might be you buy March wheat on the CME and sell July wheat on the CME. So notice, same commodity, same exchange, different delivery months, inter delivery month. The first thing I want you to do is star this type of spread. These are the ones where you're going to be asked whether you're bullish or bearish. Do you want the spread to widen or narrow? They might actually actually have you figure out a profit or loss on this type of spread. So we are going to delve into these spreads in detail throughout this chapter. The second spread an intermarket again inter means between different. So intermarket spread is different markets. So here we're buying and selling the same commodity on different exchanges. So for example here we buy gold on the comx and we sell gold on the ICE the IC. Now why do we do that? Why buy gold on one exchange and sell it on another? Well, maybe we're arbitrageing the difference between the prices on these two markets. So, this is often done to arbitrage a slight price discrepancy that exists in different markets. The third intercomodity again that term inter between two different so here it's two different commodities. Many people will trade a relationship between different commodities. So we might buy corn, sell wheat or sell corn, buy oats. Sometimes people will trade the relationship between the price of gold and silver. So a lot of times it's a related type of commodity. Okay, corn and oats are both used to feed animals. So maybe we think there's a relationship between those prices. And when you do a spread, what you always want to do is buy the one you think is cheap, sell the one you think is expensive. Now, a spread you might see is the treasury notes over bonds, sometimes actually abbreviated NOB, notes over bonds. Here we're doing a spread and playing the difference between the prices of the T-note futures and T-bond futures. Now remember what moves bond prices whether they be T-notes which are generally maturities of 2 to 10 years and T- bonds which are generally maturities over 10 years is interest rates. If interest rates go up remember bond prices go down. If interest rates go down bond prices go up. So if we expect the yield curve to flatten what does that mean first of all? Well, normally shortterm instruments yield less than long-term instruments. If people are willing to invest longer out in maturity, they generally expect a higher yield. So, generally, when we look at the yield curve, where are yields? Short-term yields will be lower than long-term yields. That would be a normal yield curve. Well, if the yield curve flattens, if you think about it, the relative yields, short-term rates are rising compared to long-term rates. So, sort of short-term rates going up or long-term rates coming down to flatten the yield curve. So, notice what we expect here. We expect short rates to go up compared to long rates. So notice if we expect the yield curve to flatten, if we're expecting those short-term rates to go up compared to the long-term rates, short-term rates up, bond prices down. So notice we short the T-note and go long the T-bond, which is the longerterm instrument. Why? If we're that yield curve is flattening, just think of the short-term rates may be coming up to where the long-term rates are. If those short-term rates go up, the price is falling. So, we short the near-term now or the shorter the shorter instrument. What about if we expect the yield curve to steepen, right? Then the long rates are even going higher up than those short rates. So, if those long rates went even higher up, okay, well, or the short rates are coming down, right? So if those long rates are going higher up, rates up, price is down. So then we want to be short the longer term instrument, the T-bond futures. So many people play the relationship between short-term yields and long-term yields by trading the notes compared to the bonds. And the fourth one, the commodity product spread. Here we're spreading the difference between a raw product and the processed product. So you take a position in the raw commodity and an opposite position in the processed or refined commodity. And there's two examples we want you to know by name for the test. The first one is the crush. The crush is generally for soybeans. So when you crush a soybean, you get soybean oil and soybean meal. The crush would be going long the raw product, the soybeans, and short the end products, the soybean oil and the soybean meal. Why would we do this? Because again, we always want to buy what we think is cheap. So going long soybeans must mean we think the price of soybeans is cheap relative to the price of the soybean oil and meal. So by buying the soybeans and selling the oil and meal will profit if we're correct that soybean prices are cheap compared to soybean oil and meal. What we expect to happen is the price of the beans to go up in comparison to the oil and meal. And if we're right that the price of soybeans is cheap, people who actually crush soybeans for a living will be actively engaged in crushing as many as they can because they can buy cheap soybeans and turn it into expensive oil and meal. Well, that demand for the soybeans will cause the soybean prices to go up. The supply of oil and meal coming on the market should cause that those prices to go down and we will profit on our spread. Now, there is also something called a reverse crush, which would be selling the soybeans. And this is what I want you to know that the crush is buying the beans and selling the end products. The reverse crush is selling the soybeans and buying the end products. We have that same exact thing with crude except the spread is called the crack spread. the crack spread. And again, what would be the crack spread? Where you're buying the raw product, which is the crude oil. So, you go long the crude oil and short the end products, the gasoline and heating oil. Know that that's called the crack. So, what would the reverse crack be then? It would be selling the crude oil and buying the end products. For the rest of this chapter, we really turn our attention back to the interd delivery month spreads. So, we're going to be looking at buying one delivery month, selling another delivery month. Well, when we have these interd delivery month spreads, one question the series 3 might ask you is, is the spreader bullish or bearish? And this presents problems for people because we bought one month and sold the other month. So we seem to be bullish on one month, bearish on another month. That's not a choice on the test. So what which one is the dominant leg of this spread that tells me that tells me whether I'm actually bullish or bearish? For most commodities, generally the spreader's market sentiment will be reflected by the near month. If you buy the near month, you are bullish. If you sell the near month, you are bearish. So, if the test asks you, is this spread a bullish and bearish? Bullish or bearish? It's a little tough because they're buying one, selling the other. Which one are we looking at? We're looking at the near month usually with a couple of exceptions I want you to memorize. We look at the near month and we say whatever we did in the near month is my strategy for the spread. Buy the near month, you're bullish. If you sold the near month, you're bearish. What's the exceptions? Foreign currencies and stock index futures are exceptions to this rule where your sentiment is determined by the position you took in the deferred month. So then we're going to look at the deferred month and say what did they do in that month. So if they buy the deferred month and sell the near month on a stock index futures for example they would be bullish if they bought the deferred month. So look at the near month that determines your sentiment except for index futures and foreign currency futures which work a bit differently. And and just a quick rationale for that on most of the other commodities you could have shortages of the commodity. So if we look at things like corn and wheat, right, it's really determined to a large extent by supply and demand of the crop. And if we have a shortage, what we generally expect to happen is the near-term month to increase in price more than the distant month. When there's a shortage of that commodity, remember what causes a market to invert is generally a shortage. Prices rise, the near month might actually invert and go over the longer deferred month. But with currencies and index futures, you really don't have the same type of supply and demand and shortages. So, they work differently. Um, but it's not an essay test. All you have to do is identify it. Now the next question they ask is to profit does the spreader want the difference between the prices to get wider or closer together narrower. So the spread trades get their name from the difference or spread between the prices of the two contracts that you buy and sell. So if I buy corn at $3 the near month, and I sell the deferred month at 320, that difference is 20. That's sort of the spread between the two different months that I traded. Well, I either want that difference to get wider apart, so in other words, more than 20 cents, or closer together, less than 20 cents. Well, the easy thing to remember is that the buyer and what do we mean by the buyer? How do I determine whether I'm a buyer or a seller when again I actually bought one and sold one? Well, here's what you look at for this. Look at the more expensive leg of the spread. Whichever number is bigger. So, if I did one for three and one for 320, that those are the two different delivery month prices, then I'm looking at the 320. If I bought that one for 320, then I paid more than I received, I'm more like a buyer. Okay? I'm more like a buyer. So, here the trick is you look at the expensive leg of the spread. So, if I traded corn futures, one leg had a $3 price, the other had a 320, then I look at the 320. If I bought that more expensive leg, then I want the price or the spread between those two legs to widen to widen. And the rationale behind that is, if you think about it, if I bought the more expensive leg and sold the cheaper leg, when I unwind the spread, I'm going to be selling the more expensive leg and I'll be taking in money because I'll be selling the more expensive leg and buying back the cheaper leg. So, if you initially bought that more expensive leg, when you unwind the spread, you're going to be selling the more expensive leg and taking in money. How much do you want to take in? More or less than 20 cents? You want to take in more than you originally paid out? So, I want to take in more than 20 cents. So, if I take in 25 cents, I made a nickel because I wound up taking in a bigger difference than I paid. When you sell the more expensive leg, then you initially take in money. But to liquidate out of that spread, you're going to have to buy back the more expensive leg and pay out money. So when you liquidate that spread, you're going to have to buy back the more expensive leg and pay out money. How much do you want to pay out? You want to pay out less. You want the difference that spread to have narrowed. Now, if you understand that, that's great. If you don't, there's a little trick that some people use to get the question right on the test. And you'll probably see this question asked once on your test. And there's a little trick people use. Notice buyer has five letters, widen has five letters, seller has six letters, narrow has six letters. So just match it up that way. And remember, how do I know whether I use the buyer or the seller? look at the more expensive leg and say, "What am I doing with that leg? Am I a buyer of that leg or a seller of that leg?" Look at the more expensive leg. And that always works no matter what the commodity is. There's not the same exceptions for index futures and currencies for this rule. So, you look at the more expensive leg that determines whether you're a buyer or a seller. Buyers want the spread to narrow. Sellers want their spread to widen. But the way you learn this is by applying it a couple of times. So let's take a look at an example. An investor shorts March corn at 319 and buys July corn at 323. So the first question they could ask us is just what type of spread this is. And notice again interd delivery because we have different delivery months. We're selling March buying July. So this is an interd delivery month spread. Next question they could ask is is it bullish or bearish? Or they could ask us, do we want the spread to widen or narrow? And again feel free to pause the video for a second here and answer the questions on your own first. Always a good idea to try to think through these things. So bullish or bearish, widen or narrow. Okay, let's take a look at it. So how do we determine whether we're bullish or bearish? What was the rule again? Well, the sentiment is reflected in which leg of the spread? The near month. So, we look at the near month. We shorted March. We bought July. And always assume that the month that comes more on a calendar is the near month. No matter what month you're actually in when you're testing, March comes before July on the test. Okay? March comes before July. Assume they're in the same year. So we look at the near month which is March. What did we do? We sold March. We shorted March. That determines our position. So we are bearish since this we sold the near month. Second question. Do we want this spread to widen or narrow? So how do we do that? Again we look at the expensive leg. 323 or $323 is more than $3.19. So that expensive leg is the July that we traded for 323. What did we do there? We bought the more expensive leg. So we're more like a buyer. So what do we want to happen? We want the spread to widen since the investor bought the more expensive leg. See, when we go to liquidate this spread, we'll be selling the July and buying back the March. will be selling the more expensive leg and we hope to take in more than the 4 cent difference that we paid when we put on the spread. Notice when we put on this spread, we paid a net of 4 cents because we bought the 323, sold the 319. So the difference at the time we put on the spread was 4 cents. We're hoping that difference widens so that when we sell the July leg and buy back the March leg, we take in more than that 4 cents. Let's take a look at a spread example where we figure out the profit or loss. So here we sell January soybeans at 841 and buy May soybeans at 844. Soybean futures have a contract size of 5,000 bushels. So the first questions are is the spreader bullish or bearish? Does he or she wanted to widen or narrow? And again, always feel free to pause the videos and figure out on your own. Okay, let's take a look. So, are we bullish or bearish? So, here what do we look at? Well, again, our sentiment is reflected by our position in the near month with two exceptions, foreign currencies and stock indexes. This is not one of the exceptions. So what are we looking at the near month? What did we do in that near month? Well, January is the near month. Okay. So what did we do? We sold it. So we are bearish. We sold the near month. So we are bearish. Well, what was the initial spread? It was a 3 cent difference. Well, do we want the spread to narrow or widen from that 3 cents? Here we have to figure out what did we do to the more expensive leg? Well, we look at these prices$8.41 and$8.44. Which is the more expensive leg?$8.44. What did we do? We bought it. So, we're more like a buyer. So, we want that spread to widen because we bought the more expensive leg. And there's no exceptions to that rule. If you buy the more expensive leg, you want the spread to widen. Why? Because when we go to get out of this spread, we'll be selling the more expensive leg and taking in the difference. We want to take in more. Well, let's see where they tell us prices go later. The positions are offset when January soybeans are at 8.40 and May soybeans are at 8.47. So, did the spread widen or narrow? what's the resulting profit or loss and how much money does that equate to? So, here we're getting into a little bit more detail. We're actually figuring out the profit or loss for this trade. And again, feel free to pause the video. Let's take a look at it. Well, what is the spread when we offset our position? The spread is now 7 cents. the difference between January and May 840 and 847. So, did it narrow or widen? It widened from 3 cents to 7 cents. Well, notice that's what we were hoping for because we originally bought the more expensive leg and paid 3 cents. Now, when we liquidate, we'll be selling the more expensive leg and taking in the difference, which is 7. So that results in a profit of 4 cents. How much is 4 cents equal to? Multiply it by the contract size of 5,000 bushels and we made $200. So we wanted that spread to widen. It did. So we make the difference between in this case what we paid when we put on the spread a net of 3 cents versus what we took in when we offset the spread which was 7 cents. Now, some people do get confused about the profits and losses on spreads. So, let me show you a second way you could do this for the test that some people like more. If they ask you the profit or loss, you can treat this as two trades and just figure out your profit or loss on the individual trades, then put it together. What do I mean by that? If you think about this, we traded January soybeans and we traded May soybeans. We could figure out our profit or loss on the January trade and the May futures trade. So, if you look at January, we sold them at 841, bought them back, okay, at 8.40 and made a penny. How did we do on the May trade? the May trade. We bought them at 844. We wound up selling them at 847. So, we sold them for more. We made three pennies. So, we made one penny on the January trade. We made three pennies on the May trade. Notice we made that four pennies. So, we could have figured it out each one independently. So, some people like to do that because they don't sort of recreate the whole wheel for figuring out profits and losses on spreads. They just treat it as a speculation problem like I've like you've done every other speculation question and just treat it as two trades. How did I do on my January trade in this case and how did I do on the May futures trade? And you will probably see a couple of questions where you have to figure out a profit or loss on a spread. Let's take a look at another spread example here. We sell the September E- mini S&P 500 futures at 285310 and we buy the December E- Mini S&P 500 futures contract at 2830.75. And they tell us the E- mini S&P 500 futures have a multiplier of $50. Now, the first thing to note is that the multiplier for an index futures is the contract size. That tells us each point is worth $50. Then we see the questions, are we bullish or bearish? Do we want it to widen or narrow? Feel free to pause the video while you try to answer. Okay, let's take a look at how we do it. Well, here we sell the September futures and buy the December futures. Well, a lot of people make the careless mistake because they remember your sentiment is reflected in the near month. That is true generally with two exceptions you have to know. Indexes is one of them. Currencies is the other. So here our sentiment is going to be reflected by what we did in the deferred month in the December contract. So here we bought the December contract. That's the deferred month. That's the one we're looking at since it's indexes. Since we bought that deferred month, we are bullish. Now what was the spread when we put on this? It was a spread of 22.35 points. the difference between 285310 and 2830.75. And here we see we are bullish because we bought the deferred month. Why are we looking at the deferred month? Because it's indexes. Now we do we want it to widen or narrow? Well, here what you always do is you look at the more expensive leg. Which is the more expensive leg here? The 285310 is the more expensive leg. What did we do to that leg? We sold it. So, we are a seller. And when you're a seller, remember, you wanted to narrow. Why? Because we initially sold the more expensive leg. When we go to get out of the spread, we're going to be buying back the more expensive leg and paying out money. We want to pay out less. We want the spread to narrow because we sold the more expensive leg. We're more like a seller. Seller and narrow both have six letters. Then they tell us what happens later. The positions are offset when the September futures have gone to 28.4020 and the December futures have gone to 280750. So here they're asking us to actually figure out the profit or loss on the trade. Again, feel free to pause the video. Okay, let's take a look at it. Well, what has happened to the spread? The spread is now the difference between 284020 and 280750 is 32.70 points. So notice this spread. Did it get narrow or wider? It is widened. It's a bigger difference now. Well, notice up top we were looking for the spread to do what? To narrow. It didn't. It widened. So, we have a loss. How much is that loss? It's the difference between 3270 and 2235. That loss is 10.35 points. multiply that by the multiplier of $50 per point and we get our loss of $51750. And why is this resulting in a loss? Because when we initially put on the spread, we sold the more expensive leg. We took in 2235. When we go to liquidate out of the spread, we have to buy back the more expensive leg. And how much are we paying that difference of 3270 so we wind up losing that difference of 10.35 points. Now again you could have done it as two trades. You could have said we sold September at 2853. So when we liquidate we buy back September at 28.40. Notice we bought it back cheaper. We actually made roughly 13 points on that trade. But then we also traded December. We bought it at 2830.75. When we go to sell it, we only get 2807. So notice we lost more like 23 points there. So we lost more on the December leg than we made on that September leg. You could do it as two trades and just figure out the profit or loss on each then bring them together. Now let's try a couple of activities. Take a minute to complete this activity. And we have two questions here. Feel free to pause the video, answer both, then unpause it, and we'll go through them. Okay, let's see how you did. Number one, a client believes that there will be a bullish run on soybeans. Which of the following spreads is the most appropriate? Well, this is a regular commodity. It's not one of the exceptions, the stock indexes and currencies. So, if we're bullish, what do we want to do? Buy the near and sell the deferred or sell the near and buy the deferred? Well, for most commodities, your sentiment is in the near month. So, if we're bullish, we want to buy the near month and sell the deferred month. And with a spread, you're going to be buying one and selling one. Okay? Buying one and selling one. not buying both or selling both cuz that's not really a spread. So C and D are not really spreads. A and B are spreads. Question two. A client believes that there will be a bullish run on euros. Which of the following spreads is most appropriate? Well, this is one of the exceptions. It's currencies. So what are we going to do? We're going to buy the deferred month, sell the near month. So B, sell the nearby and buy the deferred. Since this is one of the two exceptions, you have to remember currencies and indexes, your sentiment is reflected in the deferred month. Let's take a look at another activity. Here we'll figure out the profit or loss on a spread. And again, take a minute to pause the video and calculate it on your own first. Okay, let's see how you did. A customer has a spread position in pork bellies. She's long July at 38.50 and short December at 52.50. Later, she liquidates her spread when July is at 46.25 and December is at 6375. The size of the contract is £40,000. What's the profit or loss excluding commissions? Well, let me ask you a couple of additional questions. Is the spreader bullish or bearish? Do they want it to widen or narrow? Again, bullish or bearish would be reflected in the near month because this is not one of the exceptions. And do we want it to narrow or widen? We would look at the more expensive leg here. It's the December leg at 5250. What did we do to that leg? We sold it. So, we're selling the expensive leg. We want to narrow. Sellers wanted to narrow. So, we're hoping this spread narrows. Well, when we go to offset the spread, it's gone to 46.25 and 6375. So, if you did all this correctly, you would get that there's a $1,400 loss. Let's calculate it. So the initial spread when we put on the spread was 14. The difference between 3850 and 5250 comes out to the difference of 14 which we're showing here is.14 which is another way to show 14. Now since we sold the more expensive leg we are hoping that that spread narrows. Let's take a look at what happened when we offset the hedge. It's gone to prices of 46.25 and 6375. That difference is now 17 12. So notice the spread widened which results in a loss for this trader. Okay, which results in a loss of that difference which is 3 12 cents. So, it's a loss of 0.035. How do we calculate what that equals? We multiply it by the contract size of $40,000. And that gives us our total loss of $1,400. Now, again, if you wanted to, you could calculate them separately and you could say we traded July, we go long at 38.50, 50 and we wind up selling July at 46.25 and making that difference. But we also traded December. We shorted it at 5250. We wind up buying it back at 6375 and we lose that money. If you do it that way, it will come out to the same answer. And again, you'll probably see about two questions on spreads where you're actually figuring out profits and losses. Then you'll see other spreads. Are you bullish or bearish? Do you want it to narrow or widen? Okay. Is it an intermarket spread or you know the remember the crush and the crack and the notes over bonds? So you will see other questions on spreads where you're identifying the spreads. What would I do now? Again, first I would create a custom exam on spreads. Okay, spreads do give some people trouble. So, it's probably worth taking a few minutes out creating a custom exam of, let's say, 10 questions and practicing spreads. Then next, we look at really the most important topic, which is hedging. We'll look at long and short hedges. We'll calculate the results of the hedge. Very important, what's the result of the hedge? And extremely important, the third bullet will calculate the effective selling price or the effective cost factoring in the result of the hedge.