Spreading - Bull and Bear Spreads in Normal Vs. Inverted Markets

Bull and Bear Spreads in Normal Vs. Inverted Markets
Spreads are designed to manage the risk of fluctuations between prices.

A "bull spread" is a strategy designed to profit if the price of the underlying commodity goes up. This involves buying the nearby futures contract and selling the more distant-futures contract. The example we've been working with throughout the chapter, long September wheat for $4.70/bushel and short December wheat for $4.85/bushel, is a bull spread. The trader wants the price spread between the long and short positions to narrow in a normal (contango) market and to widen in an inverted (backwardation) market.

A "bear spread" is a strategy designed to profit if the price of the underlying commodity goes down. It is mechanically similar to a bull spread, except the investor goes short on the nearby futures position and long on the more distant futures position. If the trader in the example would have sold the September contract and bought the December contract, then he would be taking a position that the December price would go down. In a normal market, the trader wants prices to widen and in an inverted market to narrow.

It wouldn't have to go below the September price to be profitable, though. As we have seen, the spread is essentially a bet on the direction of change to the basis. Providing the basis narrows, which it will do as long as the near-future price stays relatively stable and the (higher) far-future price declines, the spread gains in value and can be traded away for a profit.

SEE: Vertical Bull And Bear Spreads

To review, an investor buys the near-future contract and sells the far-future contract to create a bull spread, or sells the near-future contract and buys the far-future contract to create a bear spread.

Incidentally, positions in financial commodities – particularly stock futures – are as likely to be covered by a spread as are agricultural commodities.

Brief Review of Common Processor Spreads
A processor buys raw materials (the input) to add value to the finished or end product (the output). These types of businesses tend to be long the futures contract, on the input to lock in more favorable costs, and short the futures contract on the end product, to protect against price declines. Processors use spreads to hedge. Accordingly, their margin requirements are lower. By contrast, speculators take the opposite side of both trades (sell the input and buy the output) and are subject to higher margin requirements.

  • Cattle Feeders: buy corn and soy meal futures (input to feed cattle) and sell live cattle futures to hedge against a price decline in the final product (the fatted calf).
  • Pork processor: buys hog futures (the input) and sells pork bellies (the output) to protect against their price decline.
  • Crush/Reverse Crush Spread: so named because soybeans were crushed in vats to make oil and meal, there are two varieties, to wit:
    • Crush Spread: buy soybean futures to get a good price on the beans and sell the end product to hedge against a price decline (soybean oil or meal futures).
    • Reverse crush spread: a speculative position, the trader sells soybean futures (the input) and buys soybean oil and meal futures (the output) when processing soybeans is minimally profitable for the processor.
  • Crack Spread: an industry term to describe the process of refining crude oil into distillates, it entails the trader purchasing crude oil futures and selling heating oil and gasoline futures, achieving a lower cost on the input and a hedge on the sale of the output.
Summary And Review
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