Commodities Trading Spread – Going Long or Going Short

Many investors when trading not only want to make a profit, but want to minimize their risks. A way of doing this is hedging. It’s important to realize that by choosing to minimize your risk, you do also restrict your profit potential. One of the most common hedging strategies is the spread.

Generally, commodities trades take the form of buying or selling a futures contract, and not a direct trade of the commodity. ‘Going long’ or ‘going short’ are the most basic strategies with this sort of trade.

Buying a futures contract with the belief that the price of the contract will rise before its expiration date is going long. Futures contracts are similar to buying stock or options – very few investors have anything to do with trading the actual physical commodity.

By contrast, going short is selling a contract with the idea that price will decline before expiration. New investors are often confused by this strategy, wondering how you sell something you don't own BEFORE you've bought it?

It may seem puzzling but in practice, is quite simple. Essentially, speculators borrow the contract, then buy one to make up the shortfall later.

Imagine you sell a futures contract in May for September wheat for $6.00 per bushel. A minimum amount is required for the contract, generally 5,000 bushels. If, in fact fall, the price does fall in August to $5.40 per bushel, you've made a profit of 60 cents on each bushel. Excluding commission, that's $3,000. Trading account profits and losses are settled daily, though ultimately the books get balanced by the broker buying a contract of the same type on your behalf. With your money, of course.

Mixing the types and lengths of contracts are common trading strategies. One of the simplest is some kind of 'spread'. There are several varieties, but take a simple example.

Let’s say it's May and the price for a July wheat contract is $5.90 per bushel and for a September contract the price is $6.00 per bushel. If you decide the price difference ('the spread') between the two will change before July to greater than 10 cents and you turn out to be correct, you could profit by selling the July contract(today) and buying the September contract (today). Effectively you short July and go long on September. So how do you profit from this?

If in June, the July contract has risen to $6.00 per bushel and the September to $6.25 per bushel, you 'liquidate both positions' (settle both contracts). What are the results of this? You lost 10 cents on the July contract (speculation, by nature, means you can't be right every time), but you gained 25 cents on September. You profit 15 cents per bushel (minus a small commission on the 'turn around'.) Your net gain on the contracted 5,000 bushels is $750.

If you had not shorted July, obviously you would have made a larger profit. But it's not possible to to predict the future with any certainty.

Going long and short at the same time, is essentially what hedging is. The spread strategy helps to cover you against a swing either way in the market. Of course, by minimizing your risks, your profit margin is also capped, but you are less likely to leave the market with a loss.

         

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