A Complete Guide to the Futures Market, 2nd Edition

CHAPTER 31

Intercommodity Spreads: Determining Contract Ratios

. . . many more people see than weigh.

—Philip Dormar Stanhope, Earl of Chesterfield

By definition, the intention of the spread trader is to implement a position that will reflect changes in the price difference between contracts rather than changes in outright price levels. To achieve such a trade, the two legs of a spread must be equally weighted. As an obvious example, long 2 December corn/short 1 March corn is a spread in name only. Such a position would be far more dependent on fluctuations in the price level of corn than on changes in the price difference between December and March.

The meaning of equally weighted, however, is by no means obvious. Many traders simply assume that a balanced spread position implies an equal number of contracts long and short. Such an assumption is usually valid for most intramarket spreads (although an exception will be discussed later in this chapter). However, for many intermarket and intercommodity¹ spreads, the automatic presumption of an equal number of contracts long and short can lead to severe distortions.

Consider the example of a trader who anticipates that demand for lower quality Robusta coffee beans (London contract) will decline relative to higher quality Arabica beans (New York contract) and attempts to capitalize on this forecast by initiating a 5-contract long New York coffee/short London coffee spread. Assume the projection is correct, and London coffee prices ...