Tips on Technicals - Spread
| Indicator type: |
Relative Strength/Performance Indicator |
| Used to: |
Identify relationships between two or more similar items |
| Markets: |
All markets and time frames |
| Works Best: |
All market conditions except during unusual volatility |
| Formula: |
Item 1 - Item 2. Each may be weighted. Complex spreads, including spreads of other spreads (butterfly), are possible. |
| Parameters: |
N/A |
| Theory: |
Spreads are a function of the relationship between the items and are not dependent on absolute price direction. Traders recognize that the extremes of spreads provide trading opportunities.
Weighted spreads are used when the price correspondence that is needed is not 1:1. Weighting factors are applied when the contracts being spread trade in different units and when you want to see total "dollar" returns.
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| Interpretation: |
If a spread has expanded beyond normal limits, you could buy the cheap and sell the expensive, making a profit on the subsequent narrowing of the spread. The opposite strategy could be used if the spread narrows to abnormal levels. Technical tools, such as support, resistance and trend lines, can all be applied to determine these levels. |
Basis Spreads
Basis trading is trading of the spread between a futures contract and its underlying commodity or financial asset. The more common bases traded are the bond basis and stock index bases. This theoretical spread is calculated daily by traders based on their own models. Figure 1 shows the S&P 500 basis for a five day period, tick by tick. When the basis trades outside the calculated "fair value" area, a trading opportunity exists. Basis spreads are more frequently traded intraday rather than daily because most trading occurs on a very short-term horizon. Program trading in the stock market is based solely on this spread.
In the US bond market, the basis is a weighted spread between the cash bond and the futures contract. Each futures contract delivery month and cash bond pair has its own weighting factor which reflects the changes in bond coupon and maturity. In contrast, the stock index basis is unweighted.
Calendar Spreads
A calendar spread is the simultaneous buying and selling of the same futures contracts but in different delivery months. When the spread widens or narrows, traders can profit by buying the cheaper and selling the more expensive.
Figure 2 is a calendar spread for CBT November 1993 and January 1994 Soybeans. Large changes in spreads can indicate seasonal factors affecting only the delivery month. Note that the spread in late October dropped to new lows. This may present an opportunity to buy the spread without worrying about the overall direction of the market.
Processing Spreads
A processing spread is the price difference between a raw material and its products. This difference is gross profit for the processor. The "crack" spread is the difference between crude oil and its major derivatives, gasoline and heating oil. The name originated from the process known as "cracking." The crack spread is a measure of the average refining margin and gives a the refinery some point of comparison as to how efficient the process is.
The "crush" spread is the difference between soybeans and their derivatives, soybean meal and soybean oil and is very different from the above Soybean calendar spread. The term "crush" follows from the process of crushing soybeans to obtain the oil and meal. The crush spread gives market participants an indication of the average gross processing margin and is used by processors to hedge cash positions or for pure speculation.
