Following our introduction post on spread trading, I’d like to take this opportunity to cover a guide on how a trader can use fundamental/seasonal knowledge and relative comparison to form trade ideas.
With this post, I hope it’ll inspire more traders to come out with their own spread trading ideas.
A recap: What is spread in futures trading?
In the context of calendar spread, a spread is the price difference between the spot or near-month futures contract relative to the far-month contract (or forward contract).
There are 2 key phenomena in spread trading, namely:
Contango: Contango happens when the price of the spot or near-month is lower than the far-month contract (or forward contract), producing an upward-sloping price curve.
Backwardation: Backwardation happens when the price of the spot or near-month is higher than the price of the far-month (or forward contract), forming a downward-sloping price curve.
For a more detailed write-up, check out my previous post on the introduction to spread trading.
Fundamental reasons that caused Contango and Backwardation
In this section, let’s explore why Contango and Backwardation happen in the futures market.
There are many types of assets that are available to be traded in the futures market. As such, the reasons that lead to Contango and Backwardation can be vastly different between equities futures (eg. FKLI, S&P 500), and say, commodities futures (eg. Natural Gas, Crude Oil).
For instance, Contango and Backwardation in commodities futures (Natural Gas, Crude Oil) and livestock futures (Lean Hog, Live Cattle) could be impacted by supply and demand side factors, such as:
Supply-side factors: Production, Inventory, Import, Geopolitical uncertainties like war
Demand side factors: Consumption, Export, Weather
Meanwhile, for equities futures such as FKLI and S&P500, dividends from the underlying component stocks could also lead to Contango and Backwardation effect.
Let’s explore an example of how supply & demand side factors cause Contango and Backwardation in the natural gas market:
2 of the key purposes of natural gas are heating and cooling. As such, the price of natural gas during the winter and summer seasons tends to be higher than in autumn and spring.
This is due to the higher consumption in summer and winter relative to autumn and spring (demand side factor), as well as a lower inventory especially during winter times (supply side factor).
Since most supply and demand side factors are relatively stable, this forms a recognizable seasonality pattern in the long run.
In other words, we could take advantage of the knowledge of seasonality while forming our spread trading strategy.
Developing spread trading ideas
Essentially, trading calendar spread is essentially trading the relative difference in price between 2 different futures contracts of the same instrument.
As such, it is helpful to view spread trading from 'relative' lenses (‘higher/lower than’).
Combining the perspective of ‘relativity’ with the knowledge of Contango and Backwardation previously, we can derive interesting spread trading ideas and test if there is indeed a seasonality pattern to be traded.
Let’s use our previous example on natural gas:
Since natural gas is used for heating, winter tends to be the time of the year when natural gas consumption tends to be high, while inventory tends to be low – leading to higher natural gas price in winter compared to spring, which is the season after winter.
In other words, there is usually a backwardation in natural gas price between winter (Dec – Feb) and spring months (Mar – May).
Using natural gas as an example, below are some instances of how trade ideas could be generated and tested further:
Warmer than usual winter: A warmer than usual winter would likely lead to lower natural gas consumption. As such, this could lead to a smaller price increment for natural gas in winter months. As a result, this could lead to a small price difference for natural gas in winter relative to spring.
Higher than usual inventory for winter months: A higher than usual natural gas inventory means supply would most likely be more than enough for winter. As such, this could lead to a smaller price increment for natural gas in winter months, which leads to a smaller price difference in winter relative to spring.
Combining the two instances above, a spread trader could form a bear spread trading idea, where the spread between natural gas in winter months would be narrower relative to spring months.
Verdict: Using fundamentals and the perspective of relative comparison to form spread trading ideas
So there you have it – how to form a trade idea by understanding what causes Contango and Backwardation effect in the futures market, and combining it through the lens of relative comparison!
I hope this gives you a further understanding and a start on how to form a spread trading playbook!
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Disclaimers
Any of the information above is produced with my own best effort and research.
This post is produced purely for sharing purposes and should not be taken as a buy/sell recommendation. Past return is not indicative of future performance. Please seek advice from a licensed financial planner before making any financial decisions.
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
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