Straddling, another method of trading on the
commodity markets, involves simultaneously
purchasing one delivery period and selling another delivery
period. This can be
undertaken in a variety of ways.
- The transactions can be carried out with two
futures positions on the same exchange. This is sometimes referred to as a
spread or switch.
- The two futures positions can be taken on two
different exchanges.
- Positions can be taken on two separate exchanges
of related merchandises, for example, arabica in New York and robusta at the
London exchange. This is also generally called arbitrage.
Straddle operations have the advantage of offering
lower risks to operators although, not surprisingly, at lower profits. In a
sense, a straddle is a form of hedge. Exchanges usually encourage straddling by
requiring less deposit than for a single purchase or sale. When operators
undertake straddles they are long and short of futures contracts for different
months or maturities, usually in the same commodity market. Operators buy one
month's contract in a product and sell another month's contract in the same
product or, in some cases, a related product.
The purpose of taking two futures positions is to
take advantage of a change in price relationships. The intention is to earn a
profit from expected fluctuations in the differential between the prices of the
two months. If during the interval prices rise, the profit made from the long
position will be compensated by the loss on the short position, and vice versa
if prices decline. What really matters in a straddle operation, therefore, is
the price spread between periods. It is of no consequence in which direction the
market moves. If, for example, the price spread between the July and December
position seems greater than usual, with the forward position at a premium, it
makes sense to buy the near position and sell the forward position. This assumes
that the differential will be reduced at a later date, in which case the trader
will gain.
The spread will narrow if one of the following
situations arises:
- The near position rises while the forward position
remains unchanged;
- The near position rises higher than the forward
position;
- The near position remains unchanged while the
forward position falls;
- The near position falls less than the forward
position.
Example
A speculator sells New York 'C' December 2004
(KCZ04) and buys March 2005 (KCH05) at 360 points premium March. In abbreviated
fashion, they are buying March/December at 360.
As December gets closer to the first notice day and the
level of certified stocks is rather high, the market will move out to a full
'carry' estimated by the trade to be 425 points.
Our speculator now buys December/March (buys KCZ04 and
sells KCH05) at 425, locking in a 65-point profit per lot. At $3.75 per point,
the profit is $243.75 per lot. See 08.09.04 for more on 'carries and
inversions'.