Define and Compute a Commodity Spread
A spread position is one where trading takes places on many contracts on the same or related commodity. If the price between two related commodities changes then the idea is to profit from the opportunity.
There are two main types of commodity spreads
- Inter-commodity spread – In this case a position is taken in two different but related commodities.
- Intra-commodity spread – In this case the position is taken in different maturity months for the same commodity.
An example of this would be the case of wheat and corn which are used to ethanol production and cattle feed respectively. A certain relationship exists between the prices of these two commodities i.e. they must follow a certain pattern. Therefore it is easier to trade spread positions on them. These would then be inter-commodity spreads.
Another example would be the use of pork belly spreads because their prices are easily available in the market and one can expect them to go through reasonable price fluctuations. The normal spread is when the far contract is short sold and the nearby contract is purchased when the premium of the far to near is judged as being too great. These judgments are based on the ratio of premium to transactions and the carrying charges. The three main types of spreads that can occur are as follows:
- If the price premium judged is too high then according to this all possible combination of contracts should be spread.
- This is the same as number 1 except for the fact that only one spread is permitted per combination of contracts
- This is also the same as number 1 except for the maximum holding period is determined.
AT\&T shares sell both on the Mid-West as well as the New York exchanges and the price difference in these two markets very rarely exceed that of the transaction costs in the purchase and sale of the security. If in case the spread does exceed the amount then there will be purchases on the exchange where it is cheapest and sales on the place where it is most expensive. When the buyer receives the stock he can cover the short sale and pocket the profit and this result in the risk-free arbitrage opportunity.
There are cases where there is shorting of the near contract and purchase of the long-term one which is called a reverse spread. Reverse arbitrage is of course very rarely possible.
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