Most trading strategies aim at protecting in your profits while minimizing losses and managing risk. Hedging your trades using a ‘spread’ is one such strategy.
Before we get into spreads lets do a quick recap of trading terms. Commodity trades are of two types – a purchase or a sale of a futures contract. This is also called opening up a ‘long’ or ‘short’ position. If you were expecting the contract price to go up before its expiration then you would buy it at todays price and this would be considered as going long. On the other hand, if you expected the contract price to decline before expiration you would want to sell this contract today and buy it back at a future price to profit from the difference. This is slightly counterintuitive in the beginning. How can you sell something you dont own in the first place? You sell a futures contract by borrowing it from your broker and selling it back later. Its a pretty simple trade, just sounds complicated.
Going short example:
Lets assume that you sold a futures contract in June for October wheat for $8.00 /bushel. There is a minimum amount on a contract and lets keep it at 10000 bushels in this example. Suppose the price falls in September in $7.00 /bushel. That amounts to a $1.00 profit on each bushel for a total of $10000 (not including commissions).
Lets understand the concept of a ‘spread’ using another example:
The present month is March and the price of an August wheat contract is $7.00 /bushel and for a October contract is $7.15 /bushel. Lets assume that you believe that the difference in price (‘the spread’) between the August and October is going to be more than 15 cents. So, what would the trade be? You would short the August contract and go long the September contract i.e. sell the August contract and buy the October contract.
Now, we’re in May and the August contract is at $7.10 /bushel and the October contract is at $7.35 per bushel. You decide to liquidate your positions and settle. For the August contract you lost $0.10 /bushel and you gain $0.20 /bushel for the October one. How much did you make? You made 0.20 – 0.10 = 0.10 /bushel. Since the contract was for 10000 bushels, your profit is $1000 (minus commissions).
In the above example you would’ve made more money if you only held the October contract but since there are no guarantees you are better off hedging your bets by taking a long and short position and taking a net profit in the end. The spread like other hedging strategies protects your profits while minimizing losses.
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