Gross processing margin is the difference between the cost of a raw material and the revenue generated from its finished form. Investors use this to take advantage of price differences and can buy low and sell high using option contracts. Different industries have their own formulas for determining gross margin, such as the spark spread in the electrical industry and the crack spread in the oil industry.
Gross processing margin refers to the difference between the cost of a product in its raw form and the revenue generated from it once it is polished into its finished form. For example, said margin would be the difference between the cost of oil and the positive return achieved from the sale of gas. In investment circles, investors use gross processing margin as an opportunity to take advantage of price differences between a product and the products it creates. Typically, this implies that an investor buys long on the product and sells short on the refined form of the product.
Commodities are raw materials from which other products are made, and their market price is determined by the laws of supply and demand. There can often be a discrepancy between the price of a product on the market and the amount of product revenue generated from that product. The difference between the two is known as the gross processing margin, or GPM, and is an important concept for both industries and investors.
Most industries have their own specific formulas for determining the gross margin for processing their products. For example, the electrical industry has what is known as spark spread, which is the difference between the market price of electricity and what it costs to produce it. The industry pays close attention to this spread in an effort to determine the best time to produce electricity. Similarly, the oil industry has the crack spread, and the soybean industry has the smash spread.
Investors may try to take advantage of gross processing margin by using option contracts. The typical spread position in these cases would be to buy low, or go long, on the underlying commodity, hoping that the price will rise. In turn, the investor would borrow options with the intention of selling high, also known as the short position, in the finished product created by the product, hoping that the price would fall.
This allows the investor to essentially establish their own position on how much it costs to make a typical product. For example, an investor who plays a key role in the oil industry is betting on the efforts of oil refineries to do his job well. Conversely, an investor may go against the grain in such options. In the case of trading soybeans, this would mean consuming a lot of soybean oil and food and reducing the soybeans themselves, creating what is known as a reverse crush.
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