Spreading The Word About ETF/ETN Spreads

By Brad Zigler

Anybody who’s traded in the pits knows that futures are very versatile instruments. You can, of course, express blatant bullishness or bearishness through outright purchases or sales of contracts. But you can also take more nuanced approaches to the market by trading “spreads.”

In a spread trade, you buy one contract and simultaneously sell a different, but related, futures contract. A spread, for example, could pit corn against soybeans. Such a spread wagers on the relative effect of giving over acreage to one crop versus the other. It really doesn’t matter if corn or soybean prices go up or down. It’s the relationship between the two futures that matters to the spread trader.

Now, with the introduction of commodity-based exchange-traded funds [ETFs] and exchange-traded notes [ETNs], spreads can be traded outside of a futures account. There’s no shortage of spread options available for securities investors with margin accounts. (That margin account business may be enough to keep you away from ETF/ETN spreads, though. You need to be comfortable with short sales.)

Assuming you haven’t yet been scared off, our article, “Agribusiness Outshines Gold,” might have gotten you thinking about buying ags and selling metals. (You did think about doing that, didn’t you?)

To play the spread game with commodity futures exposures, you could have used either the ELEMENTS or the iPath ETNs to good effect.

ELEMENTS ETNs are based upon the Rogers International Commodity Index. Buying the agriculture note (RJA) one-for-one against the short sale of the metals note (RJZ) could have gotten you a 13.8% net gain over the past 45 days as grains moved higher and metals languished.

A similar spread could be constructed using the iPath ETNs, which track the Dow Jones-AIG Commodity Index. Putting the agriculture note (JJA) on the long side and the metals note (JJM) on the short side would have resulted in a 23.7% return over the last six weeks.

The disparate returns are an artifact of the broader diversification in ELEMENTS notes. Dilution worked on both legs, with RJA gaining 8.9% against JJA’s 13.3% return and RJZ falling just 4.8% compared to a 10.4% decline in JJM’s price.

Still, both spreads produced the best of all worlds: returns that were higher than those of their component legs and accompanied by lower volatility.

And that’s something worth spreading around, don’t you think?