Spread trading is the simultaneous purchase and sale of two financial assets.
This kind of trading is a very important part of the future markets; especially it is commonly used on the commodity markets.
The price difference between financial contracts varies over the time but compared to the individual future positions the spread position can greatly eliminate the effect of directionality.
The basic spread position is composed of two legs, the long position and the short one.
While the main idea is to have greater profit from one leg then loss from the other it is also possible to have profit or loss from both legs as well.
There are different types of spreads:
• A spread between different but related commodities is an intercommodity spread. Typical underlyings are commodities that have similar uses and can substitute each other.
• Purchasing contracts with different expiry months but with the same underlyings creates an intracommodity spread.
• Many financial contracts are traded on more than one market. The purchase and sale of such contracts with the same underlying in two different exchanges creates an intermarket spread.
• The purchase and sale of raw materials as well as derived processed products resulting in a commodity product spread. I assume this spread is a subclass of intercommodity spreads.
In this article I will cover intercommodity spreads as part of commodity markets as well as commodity product spreads.
The attractive part of trading intercommodity spreads is a spread price limit.
For example, if Brent gains too much on the price of WTI then WTI will be more attractive to buy taking into account costs and time of transportation.
This effect brings the Brent-WTI price relationship back to the natural levels, e.g. the spread will narrow.
Therefore, even the spread price varies over a wide range there is a logical limit that stops the price to widen.
This is a good reason to start trading such spreads and there are a lot of commodity markets suitable for this.
A Crude oil refinery turns crude oil into finished petroleum products.
The difference between raw crude oil cost and the finished products is known as a cracking margin.
This margin is the refinery profit that estimates the value added by refinery and also known as a crack spread on the future markets.
A crack spread is the simultaneous buy of crude oil and sell petroleum products futures. Reverse Crack Spread or long the crack measures the difference between the selling price of crude oil and purchase price of the corresponding petroleum products.
There are 4 standard crack spreads recognizable by the number of future contracts in the position.
1. 2:1:1 – 2 crude oil converted into 1 gasoline and 1 heating oil.
2. 3:2:1 – 3 crude oil converted into 2 gasoline and 1 heating oil.
3. 5:3:2 – 5 crude oil converted into 3 gasoline and 2 heating oil.
4. 6:3:2:1 – 6 crude oil converted into 3 gasoline, 2 heating oil and 1 residual fuel oil.
Usually, crude oil quotes are USD per barrel, petroleum products are quoted in cents per contract.
Brent contracts on the ICE Europe exchange are monthly contracts with 1000 barrels per contract. WTI trades on NYMEX exchange where contracts are available for each month with 1000 barrels per contract.
Gasoline RBOB that trades on NYMEX has monthly contracts, 42 000 US gallons per contract and the price is set in US cents. Heating oil trades in the same way as Gasoline, e.g. 42 000 US gallons per contract and the price is in the US cents.
Taking into account the specification, we must convert gallons to barrels in order to receive crack spread price in dollars per barrel. 42 gallons is 1 barrel and we can replicate 3:2:1 crack spread:
3:2:1 = (2 Gasoline futures+1 Heating Oil futures – 3 Crude oil futures ) /3
this converts into
3:2:1 =( 2 Gasoline * 42 000 + 1 Heating Oil * 42 000 – 3 Crude Oil * 1000 barrels) /3
that simply yields
3:2:1 = (2 Gasoline * 42 + 1 Heating Oil * 42 – 3 Crude Oil ) / 3
I have constructed a simple 3:2:1 crack spread using the above formula Excel file.
We see if a crack spread is a positive number then the price of the refined products is higher than that of crude oil. If the spread is a negative number than the refined products are priced at less than the cost of crude oil and it is not profitable for the refinery.
By analyzing the picture above I can say there is some trading idea that came up to my mind. Especially, when the price is very the zone of $5 – $10 I would consider a signal to buy. $35 seems to be a current resistance level.
WTI versus Brent is another type of spread that is very interesting. If you analyze the relationship prior to 2011 you will notice the prices to be very close to each other. However, in 2011 the prices had differed greatly. Here is the picture showing the difference between WTI and Brent.
This type of spread has nothing to do with cracking process but gives good opportunities for those who understand the fundamentals behind the spread price.