Walking Down the Spreads Line

Dr. Ken Rietz

This is the monthly spreads issue. This month we will give the crack spread, as usual, and cover the calendar spread. The calendar spread can be applied to options or futures, but there are major differences between the two. I will very briefly cover the option version, since it introduces the concept simply, but then focus on the futures version. The whole topic is quite complicated, and I can only present a framework for calendar spreads.

First, we cover the crack spread using the standard 3-2-1 ratios, starting with the graph. (I covered this spread in some detail in the original spreads issue).

Figure 1: The crack spread for WTI crude since 2023, in dollars per barrel

You will notice the crack spread has changed little over the past few months, even though the retail price of gasoline has continued to drop, but more slowly than a few months ago.

The calendar spread can be used by retail traders using options, where it is typically used to generate income. You choose an underlying stock or commodity and buy a longer-dated option and sell a shorter-dated option, normally with the same strike price. The intention is to use the fact that shorter-term options have greater time decay than longer-dated options. The position is closed (cash settled) at or near the expiration of the short-dated option.

The futures calendar spread is quite different. In common with the option calendar spread, the trader buys a longer-dated future and sells a shorter-dated future. While the futures spread can be used to generate income, it is more often used as a hedge. The intention is to take advantage of expected time-based relative changes. The futures spread is typically held to the end of the longer-dated option. This means buying the commodity and storing it until it is sold. This then involves the cost of carry, which can be reflected in the prices set in the futures contracts.

A calendar spread is inherently less risky than two single futures contracts, since the two prices will respond similarly to market changes, so the difference in the prices will fluctuate less. This is why the margin for the spread is much less than the sum of the margins if the two trades were independent. Calendar spreads can also be very useful in arbitrage. These are just some of the reasons to include calendar spreads in your futures strategies.

Here is an example of the graph of a calendar spread, specifically a spread on corn futures from March to December, which encompasses the bulk of the corn season.

Figure 2: The corn futures spread from Mar to Dec, for 2019 to 2025

There are a few interesting features that show up here. The prices of the spreads can change rather dramatically during the course of a year, meaning that this should be used only by those with considerable experience. But more importantly, there is no clear pattern that can be discerned about when prices go up or down. The reason is that the price of corn is affected by numerous exogenous factors, such as the global weather, varying demand, shipping conditions, and tariffs. Knowing which factors to pay attention to requires a careful hand.