Carrying Charge Spreads

This section covers the first named spread type and the gap it trades. Get the cost-of-carry relationship straight here, because the bull and bear labels in the next section are just directional bets placed on this same gap.

Same Commodity, Two Delivery Months

A carrying charge spread is long one delivery month and short another delivery month of the same commodity. It goes by several names that all describe the same position:

• Intra-market (within one market)
• Intra-commodity (within one commodity)
• Inter-delivery (across delivery months)
• Calendar spread (across the calendar)

Both legs are the same commodity, differing only in delivery month and in which leg is long versus short.

• Example: long May corn and short July corn is one carrying charge spread; short May corn and long July corn is the opposite. Both legs are corn. Only the month and the long/short assignment change.
• Because both legs are the same commodity, a broad move in corn hits both legs together and largely cancels, so the position is exposed almost entirely to the change in the month-to-month gap, not to the outright price of corn.

Think of it this way: you are not betting on where corn is headed. You are betting on how far apart two months of corn will trade. The overall price of corn can wander in either direction, and the spread barely notices, because both legs move with it.

What Sets the Gap: The Cost of Carry

In a normal (carrying-charge) market, the deferred (later) month trades above the nearby (earlier) month by roughly the cost of carry. The cost of carry is what it costs to hold the physical commodity from the nearby delivery date to the deferred delivery date:

• Storage (paying for warehouse space)
• Insurance (protecting the stored commodity)
• Interest (the financing cost of money tied up in the commodity)

The deferred contract embeds those holding costs, which is why it sits at a premium to the nearby in a normal market.

Why does the deferred trade higher? Anyone delivering against the deferred contract has to carry the commodity longer, paying storage, insurance, and interest the whole time. The deferred price has to cover those extra costs, so it trades above the nearby by about that amount.

Exam Tip: Gotchas

• In a normal (carrying-charge) market the deferred trades OVER the nearby, not the other way around, because the deferred embeds the storage, insurance, and interest of carrying the commodity longer. A question that puts the nearby at a premium in a normal market has it backwards: nearby-over-deferred is an inverted market.

The Gap Has a Ceiling but No Floor

The size of the gap between the two months is not symmetric in how far it can move each way. This asymmetry is a favorite exam trap.

• Ceiling (about full carry): When the deferred's premium over the nearby equals the full storage-plus-insurance-plus-interest cost, the market is at full carry. The market normally will not price the deferred much beyond full carry, because anyone could buy the cheap nearby, store it, and deliver it against the deferred for a near-riskless profit. That arbitrage buys the nearby and sells the deferred until the excess is competed away, so the gap is capped near full carry.
• Floor (none): The gap has no natural floor. If nearby supply tightens, the nearby can rise to a premium over the deferred, flipping into an inverted market. There is no theoretical limit to how far the nearby can trade over the deferred when supplies are short.

The gap between two delivery months of one commodity is the same basis and carrying-charge relationship from the basis unit, applied here as the thing the spreader trades directly. Whether the spreader wants the gap to widen toward full carry or narrow toward inversion is the whole subject of the next section.

Exam Tip: Gotchas

• The gap can only widen to about full carry, but it can narrow and invert without limit. Arbitrage keeps the deferred from pricing much beyond storage plus insurance plus interest, so a widening gap has a cap. A narrowing or inverting gap does not, because a nearby supply squeeze can send the nearby to any premium over the deferred. Treating the two directions as symmetric is the trap.
• Full carry is a practical ceiling, not a rule the market always reaches. Markets rarely trade all the way to full carry, because speculators step in front of it, but the arbitrage still keeps the deferred from pricing meaningfully beyond it.