Why are Watching Spreads in Commodity Futures Important?

by Tres Knippa, Lotus Brokerage

As a guest on CNBC and Bloomberg, the person interviewing me often is perplexed as to why I spend so much time watching, trading, studying, and talking about spreads in commodities.

First of all, some basic definition of a commodity spread is important.  The most basic definition of what I am referring to as a “spread” is the difference in price between the various contract months of a commodity.

Since I am going to use Crude Oil in today’s letter, let’s use Crude Oil to define “spreads”.  The more commonly used term is “carry spread” which basically means how much it takes to “carry” or store a commodity for a certain amount of time.

Carry costs in a commodity such as Crude Oil would be things like storage fees to rent tank space.  Carry cost in corn would also be storage rental but have an added cost for the moisture corn loses over time as you store it.

One of the most important components of carrying costs is the time value of money.  Remember your Finance 101 course?  If I am going to get a dollar a year from now, it is not worth as much as a dollar today because I have missed out on one year’s worth of interest income on that dollar.

The same holds true in commodities.  The combination of all those expenses gives us the basic definition of “carrying costs” in commodities.  Let’s take a look at how a typical spread chart of the carrying costs of Crude Oil would look:

You see the basic differences in price as the contract month extends out from the spot month?  This is a very basic glimpse as to a simple “normal” carry spread look.  Some traders will actually plot these prices on a graph which will look an awful lot like this:

 

Many traders (me included) will constantly monitor the steepness of these carry spreads.  As the front month of a commodity gets weaker to the back, then more carry (premiums to the back months) gets built into a particular market.

As more carry is getting built in to a particular market, to me, that suggests bearishness rather than bullishness.  If we were watching the graph above, the line would appear to get steeper as more and more carry gets built in to the market.

Why should this be perceived as bearish?  Simple.  If end users are more interested in storing a commodity rather than using a commodity, then that means the end user does NOT see any near term shortage of that particular commodity.

Now let’s talk about when spreads are telling us something bullish.  What happens if the spread chart we are looking at above gets LESS STEEP.  Sometimes carry spreads can completely flatten out and in extreme cases the carry spreads can actually INVERT.

When there is a premium for  a commodity in the front month, that means that the end user is trying to get hold of all the product he possibly can RIGHT NOW.  Does that sound like a bull market?  It does to me too.

Let’s talk about a real world case that happened just this week.  On Monday, October 24, 2011 the spot month of Crude Oil (December) went premium to the months trading behind it.  The flat price of Crude rallied $3.00 a barrel that day and another $3.00 per barrel the next day.  Bullish?  Good indicator?  I should say so.

My trading style in commodities starts by watching spreads and letting spreads give me a directional bias.  Fighting what the spreads are telling me has cost me far more than I care to admit.  When I let the spreads move and tell me what I should be doing in a market, I have far more success as a day trader and as a position trader.  You can follow my observations in spreads on Twitter at CMEtrader.

Editor’s Note: For updated information on this and related topics, see our new website: PremierOffshore.com

 

2 Comments

  1. Question: Do you also pay attention to HOW the spread graph is changing? For instance, is the message of the market the same when the slope increases by the longer end rising as when the shorter end is falling?

    • Larry,
      I am the admin and not qualified to answer your question. Please contact Tres using the contact form in the article.

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