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- Because a spread consists of two legs (buy and sell), one side
could partially protect the other in case of adverse price
movements. Let's look at a quick example. A trader enters a
spread position where she buys 1 gold contract with the delivery
three months out at $305/oz. and sells 1 gold contract with
delivery six months out at $310/oz., expecting the spread to
narrow. If, however, within a week the first contract goes to
$300/oz. while the second leg goes to $306/oz., the spread has
increased by $1/oz., which is the amount per ounce the trader
would be out. (If settled, the trader loses $5/oz. on the buy side,
gains $4/oz. on the sell side for a net loss of $1/oz.). Still the
trader is better off than if she just purchased the first contract
(loss of $5/oz.). Now you may ask, what if the trader had just
sold the other leg without buying the first leg? Yes, she would
have realized a gain, but no one could have predicted for sure
that the price of the gold contract would drop. It could have just
as well risen, causing a loss.As it can be seen, the sell side (short)
helped narrow the potential losses on the buy side (long) when
the prices dropped and the spread widened. A similar protection
would have been provided by the buy side against losses on the
sell side had the contracts' prices moved up and the spread
increased.
- A spread trader does not care about the price direction of the
contracts but the change in the magnitude of the spread.
Spreads are great for those times when a certain commodity is
expected to change in price but its direction is unknown. Believe
it or not, this happens often when analysis predicts price
movements but provides no conclusive hint on direction.
- If you have a short position and with the maturity date nearing
you suspect that you have to make good on the delivery (or
settle with a loss) because the price of the underlying product
has moved unfavorably, you have the option to roll over the …
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