I will reveal here a jealously kept secret among commodity traders, something you cannot find in books and you will never listen in seminars. This secret is about the “basis”, that is the difference in between the short term leg and the long term leg in a spread operation.
Let’s say that you buy May Cbot Wheat and you sell September Cbot Wheat so that basically you are riding the old crop / new crop spread since winter Wheat is planted in September / October and harvested in June / July. The difference is usually positive since a positive basis allows the storage industry to cover costs from carrying stocks from one season to the following.
It is as producers, consumers, storage players, exporters, etc. would meet in September and then decide through dealing which part of the current production will be transferred to the next one. If a big portion of the current production will be brought through storage to the next one producers will know that they cannot afford to produce a lot next year without watering the market dashing prices with a huge harvest. In this way new prices will always take into consideration the past one and there will be no disconnection in between one season and the other. Storage futures markets, that is those markets that are dominated by the supply of storage, will usually show a positive basis, alias a contango situation.
When the basis is positive allows the storage industry players to make money from one season to the other bringing ahead the old stocks. And this is what happens in the most cases since a positive basis it is not a pure game for speculators but something which is rooted in the economics of the agricultural markets, in storage and production.
It is why the “basis” in agricultural markets and over all in cereals (Wheat, Corn, Soybean and Soymeal, Soyoil, Rice, etc.) is the most powerful indicator for trend detection for traders. Viceversa a basis on 2 futures contracts that have little connections in the real economy will be not as much as trustful as with grains. When you listen traders that talk about spread trading confusing a commodity that has not a seasonal production and moreover it is not storable with something concrete such as cereals you know that they do not know really what they are talking about.
In summary always try to trade spread on cereals and on those commodities that have a seasonal production cycle and that are storable. The spread is the price for storage and it is a powerful indicator of price trends only when you really have a storage industry. When no storage industry exists it is easy that greed will bring the trader to consider a difference in prices among two futures that is only theoretical and not rooted in reality.
Cereals are the best place to start working with spreads and I would recommend to consider only the positive basis situations (contango) because when the story is tough with backwardation (a negative difference in between the short term leg and the long term one) it means that the “normal” market functioning is reversed by an exceptional situation and no trustful rules can be drawn.