Seasonal Spreads: A Great Way to Trade

06/17/2013 8:00 am EST

Focus: COMMODITIES

Markus Heitkoetter

Author, Educator, Trader, and CEO, Rockwell Trading Services, LLC

Seasonal trade opportunities arise from patterns that occur at specific times of the year, and Markus Heitkoetter of Rockwell Trading explains the details of the strategy below.

Have you heard about “seasonal spreads?” They are a great way to trade, because....

You can trade seasonal spreads on a small account,
You need only a few minutes per week,
You can trade them in addition to your current strategies.

Does Seasonality Really Exist?
You bet it does!

As an example, it's June, the start of the summer grilling season.

And what's America's favorite grill item? Hot dogs and sausage!

During summer, vacationing families prefer the convenience of processed meats. Bacon-lettuce-tomato sandwiches are extremely popular during summer months, and in general, you'll find that consumers prefer lighter meats over heavier red meat during the heat of the summer. So there's a high demand for pork during the months of June, July, and August.

On the other hand, corn being harvested in October/November means cheap feed during these months. Farmers take advantage of the lower-priced feed to fatten up their livestock, which in turn leads to a peak in slaughter sometime in December. After slaughter, supply tends to decline into May-July before slowly rising only by sometime in August.

Therefore almost every year, prices of lean hogs are rising in May and early June.

Another example is gasoline. Have you ever noticed that gas prices seem to rise during the summer months, when you're planning your vacation?

No surprise here either: Gasoline consumption is highest during the vacation and driving season. Its traditional opening is Memorial Day weekend (last Monday in May), the ending is Labor Day (first Monday in September), and the peak month is August.

Each and every year, the industry switches over from maximizing production of heating oil to that of gasoline at the end of winter. As both weather and driving conditions improve, daily consumption rises. But as it does, the industry must also be accumulating inventories in preparation for summer. This combination of rising consumption and inventory accumulation accelerates demand, typically driving prices up.

What about the financial markets?

Have you ever heard of the saying "Sell in May and Go Away?"

Take a look at this chart, courtesy of Bloomberg:

chart
Click to Enlarge

As you can see, the monthly return of the S&P 500 underperforms from June through September.

How to Take Advantage of Seasonality?
Well, you could simply trade the outright commodity. Using the examples above, you could simply sell lean hogs or buy gasoline futures.

But when trading commodities, there's always the risk of limit moves against you. And what if seasonality is “out of whack” this year and the prices of gasoline futures falls instead of rising?

When trading outright futures, you could lose your shirt.
The answer? Seasonal spreads.

NEXT PAGE: Advantages of Seasonal Spreads

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Advantages of Seasonal Spreads
As you know, futures contracts have a defined shelf life. They expire as options do. Therefore you can trade futures contracts in different expiration months.

Using the example above, you can trade lean hog futures contracts expiring in June, July, August, October, December, etc.

When trading seasonal spreads, you simultaneously buy futures contracts that expire one month, and sell futures contracts that expire in a different month, thus creating a “calendar spread” or a true hedge.

So the question is: Which expiration month should you BUY and which one should you SELL?

When trading futures, the month that's closest to expiration (aka front month) typically shows larger price fluctuations than the month that expire later in the year (aka back month).

If you are bullish a commodity, you would buy the front month and sell the back month.

Using the example above, you would BUY June lean hogs and SELL August lean hogs, since you are bullish on lean hogs.

One big advantage of trading commodities as seasonal spreads is that you are reducing your risk.

If the prices of lean hogs rise as expected, the prices of June lean hogs (front month) will rise faster than the prices of August lean hogs (back month).

If the prices of lean hogs do not rise as expected, and just remain sideways, then nothing will happen to your position. You might make some money, or lose a little bit.

However, if the prices of lean hogs decrease, then you would lose money on your long June position, but you are protected, since you make money on your short August position.

So what are the advantages of seasonal spreads?

  • Reduced Risk
    As outlined above, you are reducing your risk since you're establishing a true hedge.
  • Lower Margin Requirements
    The exchanges recognize that there's a reduced risk when you're hedged, and they reward you with smaller margin requirements. You often pay only a few hundred dollars per contract when you're trading seasonal spreads.
  • Minimum Time Commitment
    You don't have to babysit your spreads throughout the day, since you're hedged. You simply wait for the signal on the daily chart to enter your spread, and then you wait until either your profit target or your stop loss is hit. Seasonality typically lasts for a few weeks, therefore seasonal spreads are perfect if you only have a few minutes every week. That's all you need to identify opportunities and enter and exit the spread.

Summary of Seasonal Spreads
Whether you are new to trading or have been trading for a while, you should definitely consider trading seasonal spreads, especially when you have a small account or limited time throughout the day to watch the markets.

I hope that this brief introduction piqued your interest.

By Markus Heitkoetter, Founder and CEO, Rockwell Trading

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