What is an intermarket spread?
An intermarket spread is a arbitration trading strategy of various correlated instruments in the commodity futures market. Using this method, a trader places orders for the simultaneous purchase of a commodity futures contract with a given expiry month and also sells the same expiry month of a commodity futures contract closely related (eg buying crude oil futures to sell gasoline futures) . The objective is to take advantage of relative variations in the spread, or spreadbetween the two commodity futures prices.
Key points to remember
- An intermarket spread refers to the price difference between two closely related commodity futures contracts.
- Traders can employ an intermarket spread strategy by simultaneously buying and selling these closely related contracts, thinking the spread will widen or narrow.
- The crack spread, used in the oil futures markets, is a common intermarket spread strategy between crude oil and its refined products.
- A trader who executes an inter-exchange spread trades contracts on similar products on different exchanges.
- A trader who executes an intra-market spread trades calendar spreads and is in long and short futures on the same underlying commodity.
Understanding the Intermarket Spread
The intermarket spread strategy uses an exchange platform to complement the spread. A forward spread strategy involves trading a long position and short positionor the legs, simultaneously. The idea is to mitigate the risks of only holding a long or short position in the asset.
These trades are executed to produce an overall net trade with a positive value called the spread. An intermarket spread is placing long futures contracts on one product and short futures contracts on another product in which both legs have the same expiry month.
A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future.
An example of a commodity futures intermarket spread is if a trader buys May Chicago Chamber of Commerce (CBOT) of the feed corn contracts and simultaneously sells the May live cattle contracts. The best profit will come if the underlying price of the long position rises and the price of the short position falls. Another example is to use the CBOT platform to buy short contracts for April soybeans and long contracts for June corn.
The risks of intermarket spread transactions
Trading using spreads can be less risky because the trade is the difference between the two strike prices, not a forward firm position. Additionally, related markets tend to move in the same direction, with one side of the spread being more affected than the other. However, there are times when spreads can be just as volatile.
Know the economy fundamentals of the market, including seasonal and historical price patterns, is essential. Being able to recognize the potential for spread changes can also be a differentiator.
The risk is that both legs of the spread move in the opposite direction to what the trader might have expected. Also, margin requirements tend to be lower due to the more conservative nature of this arrangement.
Example of intermarket spread
There “crack propagation“refers to the intermarket spread between a barrel of crude oil and the various oil refined products from it. There “crackrefers to an industry term for breaking down crude oil into its component products. This includes gases like propane, fuel oil, and gasoline, as well as distillates like jet fuel, diesel fuel, kerosene, and grease.
The price per barrel of crude oil and the different prices of the products refined from it are not always perfectly synchronized. Depending on the time of year, weather, global supplies and many other factors, the supply and demand for particular distillates cause price changes that can impact profit margins on a barrel of crude oil for the refiner. To mitigate price risk, refiners use futures contracts to hedge the crack has spread. Futures and options traders can also use the crack spread to hedge other investments or speculate on potential changes in oil and refined petroleum product prices.
As an intermarket spread trader, you buy or sell the crack spread. If you buy it, you expect the crack spread to strengthen, which means refining margins rise because crude oil prices fall and/or demand for refined products rises. Selling the crack spread means that you expect the demand for refined products to weaken or the spread itself to tighten due to changes in oil prices, so you sell the futures contracts on the refined products and buy crude oil futures.
Other Commodity Spread Strategies
Other types of commodity spread strategies include intra-market spreads and inter-exchange spreads.
Intra-market spreads, created only as calendar spreads, means that a trader is long and short futures on the same underlying commodity. The legs will have the same strike price but will expire in different months. An example of this would be an investor who takes a long position in January soybeans and a short position in July soybeans.
A spread between exchanges uses contracts on similar commodities, but on different exchange platforms. These can be calendar spreads with different months or spreads using the same expiry month. The commodities may be similar, but the contracts trade on different exchanges. Returning to our example above, the trader will buy the May CBOT feed corn contracts and simultaneously sell the May live cattle on the Euronext. However, traders need permission to trade products on both exchanges.
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