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
Related Articles
  1. Markets

    How Does Flatiron School Work and Make Money?

    Examine the Flatiron School as it pertains to the product it offers; learn how it monetizes its product and the role the school plays as an industry disruptor.
  2. Mutual Funds & ETFs

    Top 3 Commodities Mutual Funds

    Get information about some of the most popular and best-performing mutual funds that are focused on commodity-related investments.
  3. Chart Advisor

    Agriculture Commodities Are In The Bear's Sights

    Agriculture stocks have experienced strong moves higher over recent weeks, but chart patterns on sugar, corn and wheat are suggesting the moves could be short lived.
  4. Investing News

    Glencore Shares Surge in Hong Kong

    Shares of Glencore International, a leading multinational commodities and mining company, jumped by around 15% on London Stock Exchange, after the shares had gained about 71% earlier on the Hong ...
  5. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  6. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  7. Investing

    Oil: Why Not to Put Faith in Forecasts

    West Texas Intermediate oil futures have recently made pronounced movements. What do they bode for the world market?
  8. Investing

    The Quinoa Quandary for Bolivian Farmers

    Growing global demand for quinoa has impacted Bolivian farmers' way of life. Should the American consumer be wary of buying this product?
  9. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  10. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Derivative

    A security with a price that is dependent upon or derived from ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  6. Best To Deliver

    The security that is delivered by the short position holder in ...
  1. Is a financial advisor required to have a degree?

    Financial advisors are not required to have university degrees. However, they are required to pass certain exams administered ... Read Full Answer >>
  2. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  3. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  4. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
  5. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!