Advantages of Commodity Spread Trading – Course Commodity Spread Trading

Hi again, thanks for coming back to this course
on Commodity Spread trading, I very much hope that you are enjoying the course so far,
In the last episode we began to look at the basics of spread trading covering off Futures,
what they are, how to use them and the effect of leverage that comes from trading with them,
then we moved on to look at what an actual spread is before exploring the correlation
between the various raw materials in respect to spread trading and how to profit from using
them. In this the 4th video of the course, we will
continue to look at the basics of spread trading, so we will continue to lay the foundations
in respect to this, Remember that when you want to build something solid and durable
for your future, it must be built on solid foundations
Do not worry, this isn’t going to turn into a course on how to construct a house, but
we will possibly refer to some of the raw materials that are used to build them. So back to spreads, after all this is why
you are here, in this second video on the basics we will look at the types of spreads
that we can trade and the differences between them and then move on to explore the advantages
and disadvantages in respect to each of them. Remember a spread is a two-way trade where
we buy one side and sell the other and look to profit from the change in the difference
between the two prices. Now you may be asking the question of how
can there be different types of spreads, let me explain more
Types of Spread: The first type of spread is known as an Intra
market spread and these are normally created as calendar spreads. As ever there are two parts to the spread,
you are long in one (where you buy a future), and short in the other (where you sell a future),
in an Intermarket spread you are trading on futures from the same market, but with expiry
in different months. As an example, I buy a wheat future expiring
in July and simultaneously sell wheat (the same raw material) but with the expiry in
December. The spread position will run until the expiry
of the nearest contract or until I close it. (More on closing a deal later)
The next type of spread is an Intermarket one, this can be created by Buying a contract
in a market (going long), and selling a contract with expiry in the same month (going short),
but in another market. An example, I buy a future on Beef Cattle
and sell one on Lean Hogs, both with maturity in the same month, maybe because I think that
the first element may increase against the second. I will profit from the spread if the price
of the Beef Cattle increases more than that of the lean hogs
A quick note, the expiry months, as mentioned will nearly always coincide, however, there
may be the odd occasion depending on your strategy when they may differ, we can look
at this in more detail later in the course. The important thing to remember for an Intermarket
spread is you are trading on two different but related commodities with the same expiry. Finally, the third type of spread we can trade
is an Interexchange Spread: This type of spread is less well known, and is undertaken when
you use futures of similar markets that are traded on different exchanges,
There are not many futures that offer this type of trade but an example would be trading
Wheat quoted on the Chicago exchange against Red Wheat traded on the Kansas City exchange. So now you know the 3 types of spread deal
we can enter into, I hope the concept of spread trading is becoming somewhat clearer, as I
mentioned once you begin to start to fully understand the basic theory things will start
to fall into place. But why do we trade them, let’s look at the
advantages this unique operation gives us Advantages
You may have already figured out some of the great benefits that this technique offers,
but let’s explore them a little more specifically. As mentioned at the start of this video there
are some great advantages when trading commodity spreads. These are often discussed our weekly trading
clubs, where together we discuss the opportunities and potential trades that we could do whilst
also looking at the strategy and practice of trading,
Within the community of the trading club, we have identified 7 aspects that we constantly
put into practice to take advantage of spread trading and we will now look at each in turn:
So the first advantage is Simplicity Spread trading is a technique that allows
a relative beginner with perhaps a smaller account balance to trade, please note by saying
a relative beginner that is not implying that someone with little or no knowledge of the
markets and spread trading, in particular, can suddenly start trading, as I have already
said learning to trade takes time and preparation, but once you have gained the knowledge and
started to put it into practice via some simulated trades, spread trading would provide you with
the opportunity to start to put those learnings into practice for real. Not only that, but it also requires less time
than other types of trading, why, well there is no need to continuously monitor your position,
you’ll only need to spend around 40 minutes per day to check your position and identify
possible new trades. It is a type of trading that fits in with
the rest of your everyday life, you can easily fit it in around work and family. Evaluating trades in advance makes for low
frequency but profitable trading and we would fully recommend this approach to you, as you
begin your journey with us, becoming a trader who makes a few trades but ensures that they
are winning ones, Trading spreads, buying on the side and selling
the other provides us with a protective shield against market movements, we know that Volatility
often exists in respect to individual futures prices. However given that a spread trade is a blanket
strategy, protecting users from the movement of the results of the market in making the
total position less volatile than the movement seen in an individual future, even when prices
are affected by news or sudden events. Having that protective shield in place gives
us a level of security that is not seen when other financial instruments are used, you
could say that A spread trade is disconnected from the performance of the financial markets,
news that could cause a price to drop suddenly will impact one side of the spread, however
the same movement will mean that we benefit from the other side of the spread. In our experience, our positions have not
been affected by recent political or economic events, such as Brexit or the US elections,
we have not seen any kind of impact from them. For the reasons described previously we understand
that in having a covered position, the risk to our position is lower than if we were just
trading with single futures. This in turn results in a reduction in margins
charged by brokers, they recognize that we have two sides to our trade and therefore
our exposure to market movements is reduced and reflect this in the discounts on the margin
we need to use, we sometimes see discounts of 80 – 90% compared to those required when
trading an individual future. Therefore we need less capital to operate For example, for a single futures trader,
the margin may be about 2-3 thousand dollars, but when operating with the same raw material
futures in spread trading, the margin can be down to the $300-$400 level. This, in turn, means that you can open more
spread positions with the same capital that is needed to open a single futures position. This is a great advantage for traders with
smaller accounts In addition thanks to the lower margins, the
return on capital tends to be much higher when compared to a single futures trade. Even for well-capitalized accounts, we can
make more trades and therefore better manage our entire portfolio, I won’t expand on
this now we will cover it off in the episode on money management later in the course. Given the reduction in the amount of margin
to be paid we can say that spread trading is the method that enables the most efficient
use of working capital on futures. Spread trading when compared to that of the
individual futures, has a reduced risk because it is not affected by the performance of a
single investment, Instead as mentioned previously two futures contracts are traded at the same
time. In addition to reducing the risk, this makes
it is possible to decrease the misinterpretation that could occur, between the present and
past performance. We also know that the raw material prices
will change depending on the time of the year and the seasons that they experience, for
example, the sowing, growing and harvesting season for crops or the rise and fall in demand
for oil for heating purposes based on the seasonal climatic changes. In another session, we will look in more detail
as to how you can choose spreads based on seasonal trends. There are definite reasons why, at certain
times in a given year, a future will tend to move more forcefully than at other times. Having the knowledge of when prices have moved
in the past and when they are likely to move in the future is a great advantage to have
when looking for potential trades or planning your trading strategy. You can still profit from a spread even when
the individual legs move sideways. We regularly see even when a trend is sideways,
that one future of the spread moves faster than the other, so the spread price forms
a trend of its own, it has been noted that these trends tend to last longer and be more
constant than the trend of the individual futures giving more opportunities to open
and close positions based on the movements seen. With spreads as we have said, we work simultaneously
with two contracts. We place our stop orders based on the differential
between the two prices and not the individual contracts. When we need to close out a deal we do so
by reversing the action on both contracts, we have mentioned the increased interest in
this market from institutional traders, by trading spreads we can partially mitigate
potential losses caused by the action of the institutions where they identify and trade
in areas where they would expect small traders to place their stop orders, thus mitigating
what we refer to as institutional stop hunting. In another video coming up shortly, we’ll
see how to defend ourselves against the institutions and take advantage of the changes brought
about by their market involvement. So we have covered off the advantages that
spread trading can offer us, however as with everything in life there are pluses and minuses,
good and bad so we need to also consider the disadvantages that spread trading presents. No don’t worry the pros of this kind of
trading far outweigh the cons but we need to know and understand them nevertheless. As explained, in taking a spread position
two simultaneous futures trades are executed, this, therefore, results in twice the commission
costs of a single futures trade. So we have to pay more when trading spreads
compared to single futures trades, It must be said that with Interactive Brokers we are
talking about $ 4 instead of $ 2 and that prices this low remain a pipe dream for most
other brokers, who do not let you trade for less than $10/$12, so always consider your
commission costs when trading Another disadvantage that shows itself is
Liquidity, Working with spreads often involves using longer-dated maturities. This may involve looking for trades where
there is lower than normal liquidity in the market, as a result, this can sometimes call
for a slight adjustment on prices to allow for the trade to be executed on the chosen
commodity, this needs to be factored into your strategy before placing the trade. So we have come to the end of the second episode
on the basics of spread trading. I hope you’ve got to learn the basic principles
of this technique, what the different spread types are, the advantages of using them and
what to watch out for when trading Stay with me because in the coming videos
we will enter more and more into the heart of this unique trading tool
In the next episodes we will discuss more aspects of what it takes to become proficient
at trading, and in particular the Fundamental Analysis we advise you undertake before making
any trades, as well as looking further at how futures are used and how they behave,
covering off two interesting concepts known as contango and backwardation. Speak to you soon, bye for now.

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