 Another type of energy financial derivative that we're going to talk about is spread trading. Spread trading can be used for outright speculative trading. It can also be used as a hedging tool. Spread trading is basically a technique that takes advantage of the relative price movement between futures contracts. It's the price difference or the price relationship that we are primarily interested in, not necessarily the absolute price of the futures contracts. Arbitrage is the simultaneous purchase and sale of similar or identical commodities in two different markets in the hopes of gaining a profit from the price difference. Those who are using arbitrage techniques are generally again your speculative traders. Arbitrage is not normally used to put on a hedge position. The margin requirements for spread trading are considerably lower than the requirements on single futures contracts if you recall from lesson seven each of those energy commodities. The year was a different margin requirement because you were dealing in the outright contracts themselves in a spread trade you're strictly dealing with the price difference. And also that makes them less risky than outright futures positions. Again, your exposure is relative to the shift in the price differential and not the individual contract price changes. There are two major types of spreads. There's an intermarket and an intramarket. In the intermarket spread it's the simultaneous purchase and sale of different but related commodities that have a reasonable stable relationship to each other. A few examples here. A crack spread is the name given to the price difference between raw crude oil and gasoline. In that crude oil is cracked using chemicals, using steam, and other ways to break it down into the refined gasoline. A spark spread is the price difference between natural gas that's used to generate electricity. The natural gas price and the power price converted to heat in terms of the MMBTUs basically represents the price it would cost to generate electricity. Heating oil versus gas oil. Heating oil is a derivative of crude oil and gas oil is a further refined product. So the price between these two can be traded as a spread as well. Then you have the New York Mercantile Exchange versus the International Petroleum Exchange in London. There is a relationship there between the crude oil products traded on both of those exchanges. One other example is the crack spread in the lesson on midstream processing. Processing plant operators purchase natural gas. They process it and produce natural gas liquids such as ethane, propane, butane, isobutane, and natural gasoline. Because they use a fractionation tower to produce the refined products, the purity products, we give the nickname frack. This is not to be confused with fracking the completion process for oil and natural gas wells. Intra-market spreads, they're also known as intra-commodity spreads. One example is the time spread. This is where you simultaneously purchase and sell futures contracts for the same commodity in different delivery months. So as an example, one could purchase the October 2012 natural gas contract and then sell the January 2013 natural gas contract. This would represent a storage spread. What you would do in fact, if you were hedging, is put the October gas in the ground and withdraw it from storage in January and sell it then. We also have locational spreads. This is a simultaneous purchase and sale of futures contracts for different locations. The WTI contract on the New York Mercantile Exchange, the delivery point is Cushing, Oklahoma, as previously mentioned, and the Brent Crude Oil, which is traded on the IPE. The delivery point there is North Sea. Two general rules for spread trading for those who are speculative trading and hoping just to make money off of price relationships. Rule one is if the spreads are expected to narrow, one buys low and sells high. Rule two, if spreads are expected to widen, you buy high and sell low. Here's an example of an in-trial market spread. The NYMEX September contract for natural gas in 2012 at a price of $2.80, the NYMEX January 2013 price for natural gas, $3.50. If you think the spread is going to narrow, you will buy the September 280 contract and you will sell the $3.50 January contract. Why? Because you expect, if the spread narrows, that the price of the September contract will go up, so what you've bought you will sell at a higher price, and you expect that the price of the January contract will lessen, therefore you will buy back at a lower price than the $3.50. Conversely, if you think that the spread is going to widen, you would sell the $2.80 and you would buy the $3.50. Again, what would the rationale behind this be? Well, if you expect it to widen, that means the price differential is going to be larger than the $0.70 that we see now. So if it's going to widen and you've sold the $2.80, then in order for the spread to widen, the September contract will have to devalue, which means you'll buy it back at less than $2.80 and make money on that side of the transaction. And if the spread widens, you would also expect that the $3.50 January contract would rise in value. So having bought it, you'll be able to sell that at a profit as well.