What is an 'Intercommodity Spread'

An intercommodity spread is a sophisticated options trade that attempts to take advantage of the value differential between two or more related commodities, such as crude oil and heating oil, or corn and wheat. A commodity is a necessary good used in commerce that is interchangeable with other commodities of the same type. 
A trader of intercommodity spreads will go long on one futures market in a given delivery month while simultaneously going short on the related commodity in the same delivery month.

BREAKING DOWN 'Intercommodity Spread'

Intercommodity spread trading requires knowledge of the dynamics between the various commodities being optioned. For example, wheat typically costs more than corn, but the spread can vary, from perhaps 80 cents to $2 per bushel. An intercommodity spread trader will know that when the spread between wheat and corn rises to around $1.50, the range will tend to contract and the price of wheat will drop relative to corn. Conversely, when the wheat/corn spread narrows to around 90 cents per bushel, the cost of wheat tends to increase relative to corn.

With this knowledge, a trader can go long on wheat and short on corn when the spread is widening. Or, the trader may go long on corn and short on wheat when the spread is narrowing. In this way, the trader hopes to make money by correctly predicting the price trend. Note that the trader is not concerned with the actual price of each commodity but rather with the direction and difference in the price.

Different Types of Intercommodity Spreads

Examples of intercommodity spreads include the crack spread and the crush spread. The crack spread involves the simultaneous purchase of futures in crude oil and refined petroleum products, such as gasoline and heating oil. A trader might execute what’s known as a 3-2-1 crack spread, meaning three long options on crude oil against two short options on gasoline and one short option on heating oil. The trader could also execute a reverse spread, going long on gas and heating oil, and short on crude oil.

A crush spread is similar but generally applies to agricultural commodities. It involves buying simultaneous long and short futures in a raw product, such as soybeans, and in the crushed and refined crop, such as soybean oil. For example, a trader could go long on raw soybeans but sell short on soybean oil futures.

One advantage to intercommodity trading is they often have lower margin requirements than straight futures trades.  Margin is the difference between the total value of securities held in an investor's account and the loan amount from a broker, which allows the trader to borrow more and thus make larger trades. However, leveraged trades can expose the trader to greater risk when spreads move in unexpected directions and may have catastrophic results.

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