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March 31, 2011 by Leave a Comment

Hedging with Commodity Futures: It’s All About Managing Price Risk!

Part Two:  A User’s Perspective

The goal of hedging is to transfer price risk from one party to another.  You may remember this from the initial article I wrote on hedging.  This article will focus on how users of a product can roughly lock in a price to transfer risk to another party.  If you would like to learn more about how a producer can roughly lock in a price, read my previous article here:  Hedging with Commodity Futures:  It’s All About Managing Price Risk!

Why should I hedge?

This is the question you will have to ask yourself when trying to figure out the benefits of hedging.  As a user, would you like to be able to roughly determine the price you will have to pay for a commodity in the future? The futures markets can help you do this.

Cash – Futures = Basis!

This is a very important formula to remember.  Basis is the difference between the cash price and the futures price of a commodity.  Basis consists of carrying charges and costs of transportation for the commodity to an exchange approved delivery point.  For example, if the cash corn market is at $6.93 and the futures price is $7.00, the basis would be -.07 (6.93-7.00).  As the delivery month draws near and the prices converge, basis approaches zero.

There are two types of hedges, long hedges and short hedges.  This article focuses on long hedges.  Someone who is buying the commodity later in the cash market is a long hedger.  A long hedger is someone who wants to protect themselves from price increases (user).  A long hedge is also known as being “Short the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative.  In the corn example above, if it was a long hedger, he would want the basis to get more negative.

To sum it up, a long hedger wants to protect against increasing prices and benefits when basis weakens.

Real-World Example

A feed company will need to buy 25,000 bushels of corn on December 1st.  Due to rising per capita incomes around the world, the feed company believes that increased demand for feed grain and food could result in an increase in corn prices.  The company decides to place a long hedge on March 23rd to protect themselves from rising prices.  December corn futures are currently trading at $6.15/bu and the December cash market is currently at $5.83/bu.  Each corn futures contract contains 5,000 bushels.  The feed company buys five corn futures contracts at $6.15/bu.  The feed company’s goal is to lock in a price of roughly $5.83/bu for corn.

It is now November 30th and the feed company’s concern that corn prices would rise held true.  Corn futures are currently at $7.58/bu and December cash corn is at $7.46/bu.  The company exits its futures positions and buys the cash grain.  See the table below for the sum of the transactions.

Change in Basis

Date Cash Futures Basis
03/23/11 5.83 6.15 -.32
11/30/11 7.46 7.58 -.12
= -1.63 = + 1.43 = -.20

The feed company lost $1.63 on the cash side and gained $1.43 on the futures side.  The net result of the hedge is a loss of 20 cents per bushel.

- 0.20/bu
X 5000 bu/contract
$-1000
X 5 contracts
$-5000 loss in dollars

The net price paid for the corn is calculated by subtracting the change in futures to the cash price at which the grain was sold.

Cash Price Received:    $7.46/bu
Gain on Futures:    -1.43 (reduces cost)
   $6.03/bu

-OR-

Target Price:    $5.83/bu
Adjusted by net result:    +0.20
   $6.03/bu

Basis strengthened during the hedge, causing the feed company to pay more than they had hoped.  Remember that the goal of hedging is to transfer price risk and set the price you would like to pay in a roughly determinable range.  Had the feed company not hedged, they would have been stuck paying $7.46/bu of corn!  This is quite a large difference from the $6.03 they actually paid.

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have decreased and the feed company would have lost money in futures, but they would have paid less for the cash grain.  If that was the case, a producer could have benefitted by placing a short hedge!  Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range.  Reducing exposure to market surprises allows users and producers to plan their operations more confidently.

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If you enjoyed this article, please sign up for a free subscription to “Daniels Ag Advisory” newsletter.  This exclusive grain market trading resource is reviewed daily by both individual and professional agricultural commodity traders alike.  Published by renowned grain trader, Andy Daniels, the Daniels Ag Advisory newsletter provides you with real-time advice from an expert with well over 25 years of day-to-day trading experience!

Filed Under: Hedging, Risk, Strategies Tagged With: , , , , , ,
February 28, 2011 by Leave a Comment

Hedging with Commodity Futures:  It’s All About Managing Price Risk!

This post originally appeared in FutureSource’s Fast Break Newsletter on February 25, 2011, where Drew Wilkins is a regular contributor on various futures trading topics.

The goal of hedging is to transfer price risk from one party to another.  Hedging has been used for hundreds of years to help producers and buyers protect themselves from price risk.  By hedging, producers and users can set the prices they will receive or pay within a roughly determinable range.  However, hedging is still an underutilized tool that many choose not to use.  This article will help you to understand the benefits of using the futures markets to reduce price risk.

Why should I hedge?

That is the question you will have to ask yourself when trying to figure out the benefits of hedging.  Would you like to protect your crops against a decline in value?  As a buyer, do you want to insulate yourself from a significant rise in prices?  The futures markets can be used to hedge the risk in both of these situations.

Cash – Futures = Basis!

This is a very important formula to remember.  Basis is the difference between the cash price and the futures price of a commodity.  Basis consists of carrying charges and costs of transportation for the commodity to an exchange approved delivery point.  For example, if the cash corn market is at $6.93 and the futures price is $7.00, the basis would be -.07 (6.93-7.00).  As the delivery month draws near and the prices converge, basis approaches zero.

Long Hedges vs.  Short Hedges

There are two types of hedges, long hedges and short hedges.  Someone who is buying the commodity later in the cash market would be a long hedger.  Someone who is selling the commodity later in the cash market would be a short hedger.  A long hedger is someone who wants to protect themselves from price increases (user).  A short hedger is someone who wants to protect themselves against declining prices (producer).  A long hedge is also known as being “short the basis” and a short hedge is known as being “long the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative.  A hedger who is long the basis (short hedger) benefits from the basis becoming more positive.  In the corn example above, a long hedger would want the basis to get more negative.  A short hedger would want the basis to get more positive.

To sum it up, a long hedger wants to protect against increasing prices and benefits when basis weakens.  A short hedger wants to protect against decreasing prices and benefits when basis strengthens.

Real-World Example

A farmer who has been on the fence about hedging decides to hedge his corn crop.  He thinks that prices will remain around the current level or decrease in late August when he anticipates selling his new crop.  The cash price for new crop corn is $5.52 and the September futures price is $6.28.  The farmer anticipates that he will have 10,000 bushels of corn to sell.  Since the farmer wants to protect himself against a decrease in prices, he will be a short hedger.  His goal is to lock in the price of $5.52/bu for corn.  Each corn futures contract contains 5,000 bushels.  The farmer sells two September 2011 corn futures contracts at $6.28 on 2/23/11.

It is now September and the farmer’s instincts held true.  Cash corn prices are currently at $5.00 and September futures are trading at $5.25.  The farmer sells his grain in the cash market and offsets his position in the futures market on 8/28/11.

Change in Basis

Date Cash Futures Basis
02/28/2011 5.52 6.28 -.76
08/28/2011 5.00 5.25 -.25
= -.52 = +1.03 = .51

The farmer lost -.52 on the cash side, but his short futures position had a gain of 1.03.  The net result of the hedge is a gain of 51 cents per bushel.

0.51/bu (Gain in dollars/bu)
X 5000 bu/contract
$ 2550/contract
X 2 contracts
$5,100 gain in dollars

The net price received for the corn is calculated by adding the change in futures to the cash price at which the grain was sold.

Cash Price Received:    $5.00/bu
Gain on Futures:    +1.03/bu
   $6.03/bu

-OR-

Target Price:    $5.52/bu
Adjusted by net result:    +0.51/bu
   $6.03/bu

The farmer had a goal of getting $5.52/bu of corn when he placed the hedge.  The result of basis strengthening allowed him to actually achieve a price of $6.03/bu.

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have increased and the farmer would have lost money in futures and gained money on cash grain.  If that was the case, a user could have benefited by placing a long hedge!  Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range.  Reducing exposure to market surprises allows producers and users to plan their operations more confidently.

Receive a Free Trial Subsciption to the “Daniels Ag Advisory” Newsletter

If you enjoyed this article, please sign up for a free subscription to “Daniels Ag Advisory” newsletter.  This exclusive grain market trading resource is reviewed daily by both individual and professional agricultural commodity traders alike.  Published by renowned grain trader, Andy Daniels, the Daniels Ag Advisory newsletter provides you with real-time advice from an expert with well over 25 years of day-to-day trading experience!

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February 18, 2011 by 2 Comments

Commodity Futures Trading: All Trades are Spread Trades

This post originally appeared in FutureSource’s Fast Break Newsletter on February 15, 2011, where Craig Turner is a regular contributor on various futures trading topics.

Every position you’ve had in the past, currently hold, or hold in the future can be viewed as a spread trade.  You might be saying to yourself, “I only trade the Gold, Crude Oil or Equities, I don’t trade spreads or get involved in pairs trades.”  Au contraire, mon frere, I beg to differ.  For example, when you buy crude oil, you are long a crude oil futures contract but you are giving up something in return.  You are giving up USD to be long crude oil.  Your long crude position is also a short USD position.  So if you are long crude, you are really in a long crude/short USD cross, or “Crude Oil/USD”.  You can apply this concept to any market you are long, whether it be stocks, real estate, or commodities.

Is this important?  Am I just being a smarty-pants, know-it-all broker?  Perhaps, but consider this.  Wouldn’t you want to know how much exposure your portfolio has to currency and systemic risk?  Wouldn’t you want to hedge that risk the best you can?  If this is important to you, then you need to understand the synthetic positions your current portfolio already holds.  Understanding your risk to currency and systemic risk will allow you to hedge against the next great-unknown event that causes the markets to crash.

Now that I have your attention, let’s go back to our crude oil example.  If you are long crude oil futures, what happens if the USD has a sudden rally?  Crude oil will decline because Crude is priced in USD.  This implies that if you are long crude, you also have a short position in the USD.  So if the USD rallies, there is a good chance that your “Crude/USD” position declines and goes against you.

This is the same for any asset or market in which you have a long position.  Whether the position is in stocks, gold, real estate, or commodities, chances are you own these assets in terms of US Dollars.  The opposite is true when you are on the short side.  For example, let’s say you are short Gold.  When you short Gold you are now receiving USD in return for selling Gold.  You can view this as long USD and short Gold, also known as USD/GOLD.  Your synthetic long USD/short Gold (USD/GOLD) position will tend to lose money if the USD declines and make money if the USD increases in value.

All Investments Have Currency Risk

Understanding how much risk you have in your portfolio due to currency risk is the first step in hedging against systemic risk and the next big crash.  Let’s say your portfolio is long individual stocks and equity indexes.  If you are only just long the equity market, you also have one additional giant short USD position.  If you are long 10 stocks, the S&P 500 index, the Russell 2000 and the NASDAQ, you probably also own all of those in US Dollars.  You can look at that entire position as long equities and short the US Dollar.  Sounds like a spread trade to me.

This is not just true for equity portfolios, but for futures traders too.  Let’s say you are long Crude Oil, Gold, Corn and the Euro.  You might think you have a nicely diversified portfolio of commodity futures positions.  However, they are all priced in the US Dollar (Crude/USD, Gold/USD, Corn/USD, EUR/USD).  In one sense, you have a massive short US Dollar position.  Again, it is important to remember for every long futures position you have that is priced in Dollars, your also have a short US Dollar position.  For every short futures position you have, you also have a synthetic long US Dollar position.

The US Dollar Represents the US Economy

Why does all this matter?  Who cares if all of your positions are held in US Dollars?  If that is what is going through your mind right now, then you need to consider the following.  What does the US Dollar represent?  The US Dollar represents the US Economy as a whole.  The value of the US Dollar is relative to other foreign currencies based on the strength of their economies, GDP, interest rates, employment and many other macro economic factors.  If the US Dollar represents the US Economy, then it must also represent systemic risk.  The state of the US Economy can have a major effect on the markets.  We only have to go back a few years when we were in the Sub-Prime crisis and Lehman Brothers failed to prove that point.  If you truly want to diversify your portfolio to have as little exposure to systemic risk as possible, you need to hedge out the US Dollar.

For example, let’s say a European country’s banking system is about to fail, and their largest banks need to be bailed out by the European Union.  To make matters worse, let’s assume the market was completely caught off guard, and the Euro plummets and sends the US Dollar much higher.  The Dollar rally puts downward pressure in all commodity futures priced in dollars.  If you are long Crude, Gold, Corn and the Euro, they are all declining together.  The correlation between those four futures positions becomes 1.0 because they are all priced in Dollars.  They act as one large losing trade against the US Dollar.

The same situation can happen to a portfolio that is made up of entirely individual stocks, equity ETFs and stock indices.  You may think you have a diversified portfolio, with equal weights to many different equity sectors.  However, if you are just long equities, you have a massive short USD position in your portfolio.  Think back to when the market thought Greece was going to have to default on its debt.  Did the US Dollar rally?  Yes, it did.  Did your stock portfolio lose value?  Yes, it did.  Luckily, Greece was bailed out and the market eventually made up the losses and traded higher.  However, what would happen if it was a major economy that failed?  What if it was an economy that could not be bailed out as easily as Greece (which in economic terms has an economy smaller in size than Massachusetts)?  What would happen then?  A repeat of what happened to the stock market in 2008 is not out of the question.

Hedging Systemic Risk by Hedging the US Dollar

How do traders hedge out the USD and protect against systemic risk?  The answer is simpler than you may have expected.  If you are long a market (and short USD) then you need to be short another market (and long USD).  The short USD and long USD positions will cancel each other out.

Let’s go back to our long Crude Oil example.  We are long Crude Oil, so then we must be short USD.  We are in a “Crude/USD” spread.  Now let’s say we are bearish Gold and we short that market.  We are short Gold, so then we must be long USD.  We are in a “USD/Gold” spread.

Let’s now assume those are the only two positions in our portfolio.  We are long Crude Oil and short Gold.  Take a look when we combine the two individual positions in our portfolio:

1) Long Crude, Short USD = CRUDE/USD
2) Short Gold, Long USD = USD/GOLD

CRUDE/USD + USD/GOLD = CRUDE/GOLD

We have hedged out the USD.  We now own Crude in terms of Gold.  What is important here is not the specific fact that we own Crude in terms of Gold and not USD.  The important thing to take away is the concept.  You can apply this trading technique to any market in order to hedge your currency risk, US Dollar risk, and ultimately your systemic failure risk in the markets.

When the markets crash, the US Dollar becomes a “flight to safety” asset, making most, if not all, assets priced in USD decline.  When the markets crashed in 2008 both Crude Oil and Gold declined to annual lows.  A portfolio just long crude oil would have taken a severe loss.  However, the portfolio that hedged out its currency risk would have been ride out the storm as its short positions were able to make up for the losses in the long positions.

By having a few short futures positions to go along with a few long futures positions, you greatly hedge out your US Dollar exposure.  The next time a major, unforeseen economic event happens, you will be better protected against systemic risk.  The short futures positions help diversify the systemic risk built up in the long positions.  Your ability to hedge out part or all of your US Dollar risk is an insurance policy against the unknown systemic risks in our financial system.

To learn more about Hedging Systematic Risk, please see our previous article solely dedicated to this very important subject.

Spread Trading

Traders who are aware of currency and systemic risk will actively look for alternative strategies to reduce this risk.  Many of them turn to spread trading, also known as pairs trading.  There are typically two types of spread trading, seasonal and non-seasonal.

Seasonal futures spread trading is when traders spread two related contracts based on seasonal supply and demand.  Many markets have seasonal cycles and traders will try to take advantage of those moves.  These seasonal patterns within the same market like being long old crop Corn and short the new crop.  Seasonal patterns also exist between different but related markets like Live Cattle and Lean Hogs.  The markets and months will change during the year, but one thing is the same, the traders are using historical seasonal patterns to enter and exit their positions.  If you would like to know more about this exciting way to trading the market, please see our Seasonal Futures Spread Trading article.

The second type of spread trading is what I call non-seasonal, which is just about every other kind of spread trading.  Some traders like to trade the Emini NASDAQ against the Emini S&P.  Some will trade Corn vs.  Wheat based on either fundamental or technical analysis, but not necessarily historical seasonal performance.  Others may just want to reduce their risk by getting either long or short the front month, and then do the opposite in the deferred months to hedge their systemic risk.  If you would like to know more about his kind of trading, please see our Wonderful World of Futures Spread Trading article.

All Positions are Spread Trades

Investors and traders need to get used to thinking of all of their futures positions as Spread Trades.  By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to.  If you think you could benefit from a publication that addresses the markets with these concepts in mind, then I highly recommend you register for a complimentary subscription to my weekly Turner’s Take newsletter.  With the knowledge and understanding of how currency and systemic risk can effect your investments and trading, you will be prepared for the next time we are in a financial crisis.

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Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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February 17, 2011 by Leave a Comment

The Wonderful World of Futures Spread Trading

This post originally appeared in FutureSource’s Fast Break Newsletter on June 23, 2010, where Craig Turner is a regular contributor on various futures trading topics.

Why We Trade Futures Spreads

When it comes to Futures Spreads, many traders ask us what is the benefit of spreading futures contracts.  They want to know why we often choose to spread futures contracts instead of either being long or short a single futures contract or option, or use option spreads instead.  In our experience, futures spreads, also known as pairs trading, offers the leverage of futures contracts, helps hedge systemic risk, eliminates stops, and we get this reduced risk without having to pay up for time premium as options traders do.  When you factor in opportunity available, risk management, cost effectiveness and margin efficiency, Futures Spread Trading can be a far superior strategy over flat priced futures trading, options and option spreads.

Futures Spreads Defined

Futures Spread Trading is a strategy of simultaneously buying a particular contract and selling a related contract against it.  This strategy is also called pairs trading.  In pairs trading, one market within a sector is bought and a separate market in the same sector is simultaneously sold short.  This provides an investor with exposure to the relative performance of the two commodities with limited exposure to broader market and sector performance.

For example, let’s say you think the US is in the midst of a very strong and robust recovery and growth period (I know – it is very wishful thinking).  If that is true, then small cap equities will outperform large cap equities.  Smaller companies can grow much faster than larger ones in percentage terms.  A futures spread trader would see this as an opportunity to buy the Mini Russell 2000 and sell the Emini S&P 500.  The Russell 2000 is a small cap index and the S&P 500 is a large cap index.  In times of economic recovery and growth, small caps should outperform large caps.  In times of economic recession large caps should outperform small caps.

Benefits of Spread Trading

Trading spreads limits the exposure to systemic risk.  In other words, it minimizes the risk associated with outside factors that can affect commodity prices.

Let’s take an example.  Dec Corn is trading higher at $4.00 while July Corn is around $3.50.  After studying the fundamentals and/or charts, you feel Dec Corn should drop 25 to 50 cents while July Corn will remain unchanged.

You short Dec Corn.  The next day the Fed announces it is bailing out Europe.  Money floods the US and International financial system.  The US Dollar Index plummets, and over the next month the USD decline sends Dec Corn higher to $5.00, July Corn higher to $4.50.

If you had been short Dec Corn and long July Corn the spread would still be around 50 cents and you have time for Dec Corn/July Corn to narrow, which it certainly may do.  If you were only short December Corn you lost $1.

You may have been fundamentally correct, that Dec Corn was overvalued and should be sold.  But since you did not long the July Corn, you lost money even though you were correct about the market fundamentals.  The change in the value of the US Dollar turned the trade into a loser.

We use pairs to eliminate as much systemic risk as possible.  We want our trading to be about the relative value of two commodities or crops within the same market.  We want to minimize the effect of outside market forces as much as possible.

How Spreads Make (and lose) Money

There are two types of spreads.  The first is intra-commodity spreads, also known as calendar spreads, which are in the same commodity.  Intra-commodity spreads are all about the near month vs.  the deferred month.  A bull futures spread is when the trader buys the near month and sells the deferred month.  This is a bull spread because in a bull market the near months will move up faster than the deferred months.  For example, if Crude Oil is in a bull market, the price of the nearby futures contract will increase faster than the price of crude 6 moths out, and even more than the contract 1 year in the future.

On the opposite side of that is the bear futures spread.  That is when the trader sells the near month and buys the deferred month.  In a bear market, the near months will move down faster than the deferred months.  In the futures markets, the near months have the most volume and open interest, so those months are the ones that are going to make the biggest price moves.  The near months almost always move faster and farther in both bull markets and bear markets when compared to the deferred, less traded contracts.

The only times when the contracts tend to move up and down at the same time, is during market panics and major sell offs.  In those situations investors and traders tend to “shoot first, interrogate second,” as the good gets sold with the bad.  During the sell off it is most likely the nearby and deferred are being sold equally.

The second type of spread is an Inter-Commodity Spread.  This is a spread between two different markets, like Corn Vs Wheat or Heating Oil vs.  RBOB Gasoline.  Let’s say we think farmers are going to plant more Corn than Wheat.  That would be bearish for Corn prices and bullish for Wheat prices.  We would short Corn and get long Wheat.  It doesn’t matter if Corn and Wheat go up or down in value.  All that matters is that Wheat holds up better than Corn.  If the markets rally, we want to see Wheat gain more than Corn.  If the markets decline, we want to see Corn go down more than Wheat.

Hedging Systemic Risk

We trade futures spreads to hedge against systemic risk.  You never know when the next shock to the system or market crash will happen.  We’ve learned through out the years to never expose ourselves to more risk than necessary.

When a trader in long one contract and short another, they are hedging out the USD.  The USD represents the entire US economy.  If we can hedge this out of our positions, we do so immediately.  Let’s say we are long the Crude Oil (CL).  That means we are long CL but we had to put up cash margin to get that position.  The CL contract is priced in USD.  In that case, we are not just long the CL, we are also short the USD.  If we used USD to get long CL, we have a long CL/short USD position, or a CL/USD cross.  If Greece defaults on their bonds, sending the Euro into a tailspin, the USD will go up materially.  The rising USD puts pressure on Crude Oil, sending CL down.

The only way to offset this risk is to spread Crude Oil against a deferred contract or another market.  Let’s say July Crude is the front month.  We are bullish Crude Oil and we buy July.  To cancel out the USD we sell December Crude, creating a long July Crude, short Dec Crude spread.

Why do we do this? If we are long July Crude, we are really long July Crude(CLN) and short USD, or CLN/USD.  If we short December Crude (CLZ), we are really short December Crude and long USD, or USD/CLZ.  When you combine the CLN/USD and USD/CLZ, you get a CLN/CLZ cross.  The long USD and short USD cancel out.

If some catastrophic even happens on the other side of the world, causing the USD to rally and CL to decline, my spread should be intact.  Whatever amount July Crude decreases, most likely Dec Crude will go down to.  The outside event will have been properly hedged.

Leverage and Margin

Futures Spreads should reduce your margin, but more importantly, it will reduce the leverage you are using.  When you are long the Emini S&P 500 overnight, you have overnight margin of $5625.  When you are short the Emini DJIA, you have overnight margin of $6500.  However, if you are long the ES and short the YM, the margin is not a combined $12,125.  There is a spread margin credit and the total overnight margin is reduced to $2054.  That is about a 83% reduction.

Why are margins reduced? Futures spreads are generally less volatile than being just long or short a single contract.  The exchanges understand this and reduce the margin requirements.  Futures spreads are generally less volatile because they narrow down the trading ideas and factors involved in the trade.

When you are long the Emini S&P 500, you are not just long the S&P index.  You also have exposure to the USD and the US financial system as a whole.  This is massive exposure to events and conditions that are impossible to predict or account for.  When you spread a contract, you are hedging out the USD, or outside market forces, and just making the trade about two very specific markets.  There will be fewer factors and therefore fewer unknowns by hedging out the USD.  This is another reason why the margins are reduced.

The leverage traders are using in their accounts are also greatly reduced, which is a good thing.  Most traders over leverage their accounts.  Overleveraged accounts either lead to traders blowing out their accounts on a big market move against them or slowly bleeding the account to $0 because they use stops that are too close to the normal trading range.

Stops

Futures spreads do not have stops.  They are not accepted at the exchange.  Good news is you really don’t need them if you are properly leveraged.  It is one of our favorite aspects of futures spread trading.  I can’t stand it when an event half way across the globe sends the market down (or up) and it triggers a stop in one of my positions.  I may be correct about the bullishness of Gold or Crude Oil, but a 5% decline in the Japanese Stock Market stops me out overnight, and then Gold or Crude goes up again.

The nice thing about futures spreads is they typically eliminate the outside market risks if the spreads are thought out and executed properly.  In our experience, traders tend to put their stops within normal trading ranges.  This makes the trader need to be exactly right in direction and timing for a trade, or they will be stopped out.  Why do traders do this? Because they only want to risk X amount of money in a trade.  If X amount of money is smaller than the daily trading range Y, then traders are too leveraged for the positions in their accounts.

Either the traders need to use more capital per trade, or they can reduce their margin, leverage and risk by using futures spreads.  If traders want to take a bullish position in the market, they can buy the front month and sell a deferred month.  If they want to take a short position in the market, they can sell the front month and buy the deferred market.

Markets to Spread

Any market can be spread traded.  Some markets like the grains, livestock, energies, softs and financials are more common than the indices, currencies and metals.  All markets can have calendar spreads or inter-commodity spreads.  However, all markets might not have a spread discount.  Spreading Corn vs.  Wheat gets a 60% reductions in margin because they are related markets.  Spreading Coffee vs.  Cocoa has no margin reduction because the fundamentals of the two markets have nothing in common.  If the markets are related fundamentally, there is a good chance a spread credit exists.  To find out if markets have spread credits just go to the Margin/Performance Bond section of the Exchange web site.

Historical Seasonality

Many spread traders follow seasonal trends and patterns.  Many futures markets have seasonal patterns.  Crude Oil and RBOB Gasoline tend to increase during the summer while Heating Oil and Natural Gas tend to increase during the winter.  The Grain markets are seasonally the highest in the spring and summer months and lowest right after harvest in the late fall.

Traders follow these patterns and trade the seasonal channels.  For example, this time of year the grain markets tend to go up faster in the old crop vs.  the new crop.  Traders will buy July corn and sell Dec Corn, or buy July Soybeans and sell Nov Soybeans.  Any shortage in beans or concerns about the crops will cause the near months to rally faster than the deferred months.  This seems to happen more often than not, which makes it a very popular spread trade.

Summary

Traders looking for ways to reduce risk in futures positions should seriously consider spreads.  In times like these, no one knows when the next Greece is going to happen.  Futures spreads can help protect your risk against outside market events.  Futures spreads can reduce leverage and allow traders to take positions without the need for tight stops that will most likely just stop them out.  Futures spreads allows traders to take advantage of medium to long term moves with less capital.

Spread Trading Ideas

Natural Gas

Natural Gas has broken out to the upside since the BP Gulf Oil spill.  Many traders think just getting long Natural Gas is too risky because Natural Gas can be a very volatile futures contact.  Entering a Bull Futures Spread in Natural Gas gives the trader exposure to Natural Gas but cuts down on the volatility of just being long a single contract.  The trader also does not have to worry about losing time premium like he would with a call option or bull call spread.  Here is an example of how a trader would get long Natural Gas with a Bull Futures Spread.

Buy August Natural Gas and Sell December Natural Gas at -0.600 or better.  Risk to a close below -0.700 ($1000).  Target is -0.4000 ($2000).  Initial Margin is $1688 and Maintenance Margin is $1250 per spread.

Natural Gas Chart

Natural Gas Chart

Click to View Larger Natural Gas Chart

Corn

Corn looks to have bottomed and seasonally this is the time of year when Corn has its best chances for higher prices.  Corn prices can be volatile this time of year, especially due to changes in weather and USDA reports.  Traders looking to take a bullish position in Corn but cut down on the volatility can buy September Corn and sell December Corn, which is a Futures Bull Spread.

Buy September Corn and Sell December Corn at -10.50 cents or better.  Risk to a close below -12.50 ($100 risk).  Look for a rally in old crop Corn to send the spread to -5.00 (+$275) and a very bullish market to bring the contracts to even (+$550).  Initial Margin is $270 and Maintenance Margin is $200 per spread.

Corn Chart

Corn Chart

Click to View Larger Corn Chart

Sugar

Sugar made historic highs earlier this year.  Now that the new crop of Sugar is coming in, many analysts feel Sugar will be heading back down to 12 or 13 cents a pound.  There will be price spikes in Sugar as commercial users still need to buy Sugar until the new crop is delivered to the market.  To cut down on the volatility, traders can sell October 2010 Sugar and Buy March 2011 Sugar, which is a Bear Futures Spread.

Sell October 2010 Sugar and Buy March 2011 Sugar at -0.70.  Risk to a close above -0.50 ($244 risk).  First target is -1.14 (+$492.80).  Initial Margin is $840 and Maintenance is $600.

Sugar Chart

Sugar Chart

Click to View Larger Sugar Chart

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Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Filed Under: Spreads, Strategies Tagged With: , , , , ,
February 16, 2011 by 1 Comment

Hedging Systematic Risk

This post originally appeared in FutureSource’s Fast Break Newsletter on March 10, 2010, where Craig Turner is a regular contributor on various futures trading topics.

Systematic risk is always a threat to even a well-diversified portfolio.  When it comes to trading, we are always aware of systematic risk, and look for ways to hedge it as much as possible.

What exactly is systematic risk?  It is the inherent risk of the financial markets crashing like they did in late 2008 and early 2009.  It can be caused by interest rate hikes, stock market crashes, a subprime crisis, a country defaulting on its debt (Greece?), or any event that causes massive panic selling.

When a market crashes everything gets sold except for “flight to safety” investments, and sometimes those are not even safe.  When the markets were falling in late 2008, the only assets that appreciated were the USD and Treasuries.  Gold, viewed by some as the ultimate “safe” investment, traded to annual lows into the $600s during the last stock market crash.

So how does someone hedge out systematic risk?  While you can’t hedge it out completely, there is something very important you can do to insulate yourself as best as possible.

For US markets, hedging out the USD is probably the best way to reduce systematic risk.  The USD is not only the United States’ currency, but it represents the US economy as a whole.  If you can reduce your exposure to the US economy, then you can reduce your exposure to systematic risk.  Hedging out your USD exposure is hedging your risk to sudden shocks to the US economy.

How do you hedge out the USD?  It is easier then you think.  For every US market you are long, you should try to find a position that gives you a short position.  This is something I always try to do in my Turner’s Take Newsletter.

For example, let’s say you are bullish on Corn and you think it is going to trade to 25 cents higher per bushel.  You are not just long Corn.  You are also short the USD.  Think of your trades as a cross, like the currency pairs.  When you are long the EUR, you are really long the EUR and short USD, or just EUR/USD.  When you are long Corn you have sold it in USD, which makes a Corn/USD cross.

Why is this important to realize that being long Corn is really a long Corn/short USD cross (Corn/USD)?  Let’s say there is a panic because Greece defaults on its debt.  Not only is the EUR sold heavily, driving the USD up, but a lot of “riskier” assets are sold during times of great uncertainty.  Everyone wants to get into cash and all commodities go down.  Corn falls 20 to 30 cents because it is priced in USD, and the dollar is soaring.

Nothing has changed fundamentally in the Corn market except the value of the USD.  Corn might still have better bullish conditions than before, but the rise in the USD has made your position a loser!

The good news is you can hedge out this risk if you were short a market in similar size that is priced in USD.  Let’s say not only were you bullish Corn, but you were bearish on Wheat.  Now you have a position that is long Corn (short USD) and short Wheat (long USD).  This is what the new positions look like:

1) Corn/USD
2) USD/Wheat

The USD cancels out and you are left with:

1) Corn/Wheat

If the USD rallies strong or declines rapidly, it will most likely affect Corn and Wheat the same.  If the dollar rallies strong, the loss in Corn will be mostly offset by the gain in Wheat.  This is not a perfect hedge against the USD, but it works often enough that allows traders to stay in positions when events beyond their control take place.

How does your trade ultimately gain/lose in value? By gaining or losing value relative to the two specific commodities.  Since we are bullish corn and bearish wheat, we feel that the value of corn will appreciate compared to wheat.

This is not just for fundamental traders.  Traders using technical analysis can benefit as well.  If corn has a bullish chart and wheat has a bearish chart, then the Corn/Wheat trade makes sense for technical analysis traders.

Yet another approach to the markets that hedges out the USD is seasonal spread trading, like Guy Bower and his ProTrader Digest newsletter.  Corn typically out performs Wheat in January as feed (corn) is in high demand for livestock and Wheat tends to stay steady or fall in value.  Being long Corn and short Wheat during January and February is not only a good seasonal trade; it is also a way to hedge out the USD.

Fundamental Example

In the examples below, we will cover spread trading that hedges out the USD and Systematic Risk.  We will go over how both fundamental and technical traders do this.

Fundamental Traders: Andy Daniels and the Daniels Ag Advisory are currently long July Corn and short Dec Corn.  They feel that the corn in storage is too wet to hold, and it needs to be sold into the market before it deteriorates.  That is going to put pressure on the July Corn contract, which is known as the “old crop”.

The DAA is also going to long December Corn, the “new crop.”  The old crop is in storage, and the new crop is in the ground.  The old crop, July Corn, will see selling pressure from farmers, while December will not.  By being short July and long December we are taking a bearish position in the market, while hedging out the USD risk.

Now, margin on Corn is $1,350 a contract, but for a spread in old crop vs. new crop the margin is not $1,350 X 2 = $2,700.  It is reduced to $270 per spread!  Why?  Because these spreads tend to be less volatile than just being outright long or short a single position in corn.  One of the reasons they are less volatile is because you are hedging out outside market risks (systematic risk).

Technical Analysis Example

Cotton recently had a bullish signal to get long around the same time the Sugar charts were turning bearish.  In markets that have large price moves, the corrections and daily ranges tend to be bigger than normal.  One way to smooth that out is being short one commodity and long another.

Cotton Chart

Cotton Chart

Click to View Larger Cotton Chart

Sugar Chart

Sugar Chart

Click to View Larger Sugar Chart

As you can see in the above charts, around February 10th Cotton was breaking out to the upside.  You could get long Cotton, but if you wanted to hedge out the USD risk you could also have shorted Sugar at the same time.  While there is no spread margin reduction for the two contracts, any major changes to the value of the USD would be hedged out.

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Filed Under: Hedging, Risk, Strategies Tagged With: , ,
November 22, 2010 by Leave a Comment

Commodity Futures Trading: Everything is a Cross

This post is part of Craig Turner’s Innovative Trading Concepts series.

Every commodity futures position you’ve had in the past, currently hold, or hold in the future can be viewed as a “cross”.  The most familiar “crosses” are currency pairs, like EUR/USD or GBP/JPY, but “crosses” are not just for currencies pairs.  For example, when you buy crude oil, you are taking possession of a crude oil futures contract but you are giving up something in return.  You are giving up USD to buy crude oil.  Your long crude position is also a short USD position.  So if you are long crude, you are really in a long crude/short USD cross, or “Crude Oil/USD”.

Is this important?  Am I just being a smarty pants, know-it-all broker?  Consider this.  If you are long crude oil futures, what happens if the USD has a sharp and sudden rally?  Crude oil will decline because Crude is priced in USD.  This implies that if you are long crude, you also have a short position in the USD.  So if the USD rallies, there is a good chance that your “Crude/USD” position is going against you.

All Investments Have Currency Risk

What is even more important is to realize how much risk you have in your portfolio due to currency risk.  Let’s say you are long Crude Oil, Gold, Corn and the Euro.  You might think you have a nicely diversified portfolio of commodity futures positions.  However, they are all priced in the US Dollar (Crude/USD, Gold/USD, Corn/USD, EUR/USD).  In one sense, you have a massive short US Dollar position.  Again, it is important to remember for every long futures position you have that is priced in Dollars, your also have a short US Dollar position.

The US Dollar represents the US Economy

Why does this matter?  The US Dollar represents the US Economy as a whole.  The US Dollar represents systemic risk.  If you truly want to diversify your portfolio to have as little exposure to systemic risk as possible, you need to hedge out the US Dollar short positions.  Let’s say a European country’s banking system is about to fail, and their largest banks need to be bailed out by the European Union.  To make matters worse, let’s assume the market was completely caught off guard, and the Euro plummets and sends the US Dollar much higher.  The Dollar rally puts downward pressure in all commodity futures priced in dollars.  If you are long Crude, Gold, Corn and the Euro, they are all declining together.  The correlation between those four futures positions becomes 1.0 because they are all priced in Dollars.  They act as one large losing trade against the US Dollar.

Hedging Systemic Risk by Hedging the US Dollar

How do traders hedge out the USD and protect themselves against systemic risk?  The answer is simpler than you may have expected.  You simply need to be short a few markets that are priced in US Dollars.  Let’s say you are bearish on the US Stock Market, Live Cattle, Japanese Yen and Treasuries.  Being short Live Cattle is also being long the US Dollar.  When you sell Cattle, you receive Dollars in return, so a short Live Cattle position can be viewed as a USD/Live Cattle cross.  That means if you are short the Emini S&P (ES), Live Cattle (LC), JPY and the 30 Yr Bond, you are in USD/ES, USD/LC, USD/JPY and USD/Bonds “crosses”.  The Long US Dollar positions will help cancel out a majority of the Short US Dollar positions you have from being long Crude, Corn, Gold and the Euro.

By having a few short futures positions to go along with a few long futures positions, you greatly hedge out your US Dollar exposure.  The next time a major, unforeseen economic event happens, you are much more protected against systemic risk.  The short futures positions in the S&P, Bonds, Yen and Cattle help diversify the systemic risk built up in being long Crude, Gold, Corn and the Euro.  Your ability to hedge out part or all of your US Dollar risk is an insurance policy against the unknown systemic risks in our financial system.

All Positions are Crosses

In summary, get used to thinking of all of your futures positions as “crosses”.  By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to.  With the knowledge of understanding how systemic risk can effect your commodity futures investments and trading, you will be one step ahead of the average investor and trader the next time we are in a financial crisis.

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Filed Under: Getting Started, Strategies Tagged With: , , , , , , , , ,