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  • Straddle operations - an example

     
     

    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'.

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