Series 3: 3.4.2. Inter-Commodity Spreads

3.4.2. Inter-Commodity Spreads

An inter-commodity spread is one in which the two futures contracts have different (but related) underlying instruments. These are riskier than intramarket spreads because their change in value is not just due to a change in carrying costs but also to a change in the price relationship between two related products. They might be Treasury notes and T-bonds, or corn and ethanol. The products are related, but their price relationship is much less predictable than differences in monthly prices on the same commodity. That said, inter-commodity spreads are still less risky than the sum of each of commodity’s individual futures contracts because there is a understandable relationship between the prices of the commodities that can lead to predictions between their price differences. For instance, if you believe the price of corn will increase faster than the price of ethanol, you might buy corn futures and sell ethanol futures in the same expiration month.

Example: Suppose a shortage of cattle on the market has significantly widened the spread between live cattle and lean hog prices from its historical average of 30 cents. The September contract for live cattle is 101.25 and for hogs 42.25. You expect that either high cattle prices will come down as ranchers increase their stock or hog prices will come up to meet the additional demand. Either way, a cattle-hog spread looks like an attractive option. You short September cattle and buy September hogs. Three months later in July you offset the spread at 92.40 and 46.40, respectively. The spread has narrowed as expected, and you have gained 13 cents per pound for a profit of $5,200 (40,000 lb. contract size x $0.13 = $5,200).