Intermarket Spread

What Is an Intermarket Spread?

An intermarket spread is an arbitrage strategy for trading 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 expiration month and also sells the same expiration month of a futures contract in a closely related commodity (e.g., purchase crude oil futures to sell gasoline futures). The goal is to profit from the relative changes in the gap, or spread, between the two futures commodity prices.

Key Takeaways

  • An intermarket spread refers to the price differential between two closely related commodities futures contracts.
  • Traders can employ an intermarket spread strategy by simultaneously buying and selling such closely related contracts, believing that the spread will widen or tighten.
  • 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 in similar commodities on different exchange platforms.
  • A trader who executes an intra-market spread trades calendar spreads and is in long and short futures in the same underlying commodity.

Understanding the Intermarket Spread

The intermarket spread strategy uses one exchange platform to complete the spread. A futures spread strategy involves trading a long position and short position, or the legs, simultaneously. The idea is to mitigate the risks of holding only a long or a 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 involves placing long futures of one commodity and short futures of another product in which both legs have the same expiration month.

A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a particular date in the future.

An example of an intermarket commodity futures spread is if a trader purchases May Chicago Board of Trade (CBOT) feed corn contracts and simultaneously sells the May live cattle contracts. The best profit will come if the underlying price of the long position increases and the short position price falls. Another example is to use the CBOT platform to buy short contracts for April soybean and long contracts for June corn.

The Risks of Intermarket Spread Trades

Trading using spreads can be less risky because the trade is the difference between the two strike prices, not an outright futures position. Also, related markets tend to move in the same direction, with one side of the spread affected more than the other. However, there are times when spreads can be as volatile.

Knowing the economic fundamentals of the market, including seasonal and historical price patterns, is essential. Being able to recognize the potential for spread changes can be a differentiator as well.

The risk is that both legs of the spread move in the opposite direction of what the trader may have expected. Also, margin requirements tend to be lower due to the more risk-averse nature of this arrangement.

Example of Intermarket Spread

The "crack spread" refers to the intermarket spread between a barrel of crude oil and the various petroleum products refined from it. The “crack” refers to an industry term for breaking apart crude oil into its component products. This includes gases like propane, heating fuel, and gasoline, as well as distillates like jet fuel, diesel fuel, kerosene, and grease.

The price of a barrel of crude oil and the various prices of the products refined from it are not always in perfect synchronization. Depending on the time of year, the weather, global supplies, and many other factors, the supply and demand for particular distillates results in pricing changes that can impact the profit margins on a barrel of crude oil for the refiner. To mitigate pricing risks, refiners use futures to hedge the crack spread. Futures and options traders can also use the crack spread to hedge other investments or speculate on potential price changes in oil and refined petroleum products.

As an intermarket spread trader, you are either buying or selling the crack spread. If you are buying it, you expect that the crack spread will strengthen, meaning the refining margins are growing because crude oil prices are falling and/or demand for refined products is growing. Selling the crack spread means you expect that the demand for refined products is weakening or the spread itself is tightening due to changes in oil pricing, so you sell the refined product futures and buy crude futures.

Other Commodities Product Spread Strategies

Other types of commodity spread strategies include intra-market spreads and inter-exchange spreads.

Intra-Market Spreads

Intra-market spreads, created only as calendar spreads, means a trader is in long and short futures in the same underlying commodity. The legs will have the same strike price but expire in different months. An example of this would be an investor going long in January soybean and short in July soybean.

Inter-Exchange Spreads

An inter-exchange spread uses contracts in similar commodities, but on different exchange platforms. They can be calendar spreads with different months, or they can be spreads that use the same expiration month. The commodities may be similar, but the contracts trade on different exchanges. Returning to our example above, the trader will purchase the May CBOT feed corn contracts and simultaneously sell the May live cattle on the Euronext. However, traders need the authorization to trade products on both exchanges.

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