- 1997: Volume 6, No. 6 Chartist Corner: Spreads

Spreads are the differences between the prices of two items. They are often used when looking at items which have some underlying relationship, such as two stocks in an industry or two delivery months of the same futures contract. Spreads are more a function of the relationship between the items and less dependent on absolute price direction.

Traders recognize that the extremes of spreads provide trading opportunities. If a spread has expanded beyond normal limits, you could buy the cheap and sell the expensive, making a profit on the subsequent narrowing of the spread. The opposite strategy could be used if the spread narrows to abnormal levels. Technical tools, such as support, resistance and trendlines, can all be applied to determine these levels.

Spreads provide lower risk trades because knowing the future direction of the market is less important than its interrelationships. They are also lower cost trades due to lower margin requirements. In many cases, the trade is a combination of contracts (longs and shorts), even though quoted as a single price.

Weighted spreads are used when the price correspondence that is needed is not 1:1. Weighting factors are applied when the contracts being spread trade in different units and when you want to see total "dollar" returns or to depict a situation involving other ratios.

Basis Spreads

Basis trading is trading of the spread between a futures contract and its underlying commodity. The more common bases traded are the bond basis and stock index bases. Futures are usually priced at a premium to the cash market with eventual convergence on expiration. This means that the longer the time before expiration, the wider the spread. This theoretical spread is calculated daily by traders based on their own models. Figure 1 shows the S&P 500 basis for a five day period, tick by tick. When the basis trades outside the calculated "fair value" area, a trading opportunity exists. Basis spreads are more frequently traded intraday rather than daily because most trading occurs on a very short-term horizon. Program trading in the stock market is based solely on this spread.

Figure 1

The premium of the futures contract over the cash index is due to the ability of the futures contract to control a much larger "dollar" value of stocks with a much smaller capital risk. This is the same as for options. When the basis becomes negative, the futures is trading as a discount to the cash and it may indicate a very bearish sentiment in the market. The key is that the spread will return to an established trading range and not that the market will go down.

In the U.S. bond market, the basis is a weighted spread between the on-the-run cash bond and the futures contract. Each futures contract delivery month and cash bond pair has its own weighting factor which reflects the changes in bond coupon and maturity. In contrast, the stock index basis is unweighted.

Trading of the basis is done based on whether you feel the premium is too high (sell the basis) or too low (buy the basis) with profits coming from its correction. Basis correction is much smaller than other spreads and occurs far more quickly.

Calendar Spreads

A calendar spread is the simultaneous buying and selling of the same futures contract but in different delivery months. Futures contracts which expire in the nearby month are usually at a discount to the far month. The amount of the discount, has to do with the cost of carry, opportunity costs of the contract and underlying assets, and is generally within a constant range. When the spread widens or narrows, traders can profit by buying the cheaper and selling the more expensive. The notable exceptions are fixed income futures which have the nearby month at a premium to the far month. This is due to the interest rate risk of holding longer "maturities."

Figure 2 shows a daily calendar spread for CBOT November 1993 and January 1994 soybeans. Large changes in spreads can indicate seasonal factors affecting only the nearby delivery month. Note that the spread in late October dropped to new lows relative to the rest of the chart. This may present an opportunity to buy the spread without worrying about the overall direction of the market.

Figure 2

Processing Spreads

A processing spread is the difference between a raw material value and the values of its products. This difference is gross profit for the processor before labor and overhead. The "crack" spread is the difference between crude oil and its major derivatives-gasoline and heating oil. The name originated from the process known as "cracking," whereby crude is broken down into its component products. The crack spread is a measure of the average refining margin and gives a specific refinery some point of comparison as to how efficient the process is.

The "crush" spread is the difference between soybeans and their derivatives-soybean meal and soybean oil and is very different from the above soybean calendar spread. The term "crush" follows from the process of crushing soybeans to obtain the oil and meal. The crush spread gives market participants an indication of the average gross processing margin. It is used by processors to hedge cash positions or for pure speculation.

Other Commonly Used Spreads

In the U.S. fixed income market, there are spreads between maturities, such as the NOB spread (Notes - Bonds) and spreads between quality levels, such as the TED spread (Treasury bills - EuroDollars). The MOB spread measures Municipal bonds - Treasury Bonds.

Other fixed income spreads involve interest rates in different countries. The French-German and the Dutch-German bond spreads are used because the economies of these countries are somewhat related.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.