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April 11, 2013 by Leave a Comment

What Does the Miami Heat Win Streak Have to Do with Spread Trading?

As many basketball fans may know, the Miami Heat recently had a 27 game winning streak, which was the 2nd longest winning streak in NBA history. It ended on Wednesday, March 27, 2013 when they visited my Chicago Bulls in a game that a lot of folks thought the Heat should have won easily.

The Chicago Bulls were set to play the game without their superstar Derrick Rose, All-Star center and arguably the heart of the team, Joakim Noah, shooting guard Rip Hamilton and shooting guard Marco Belinelli.

The Heat, lead by LeBron James, Dwayne Wade and Chris Bosh, was at full strength and playing like a well-oiled machine.

So why am I mentioning this on a futures trading blog?

Good question. The point spread on this Heat vs. Bulls game was -5, meaning that the Heat were favored by 5 points. Because the Bulls were missing key players and Miami appeared untouchable throughout their win streak, many in the sports gambling world thought the Heat would win by much more than 5 points. Indeed, they viewed this 5 point spread to be inaccurate and believed that it should be much larger.

To be clear, I’m not comparing gambling on a basketball game to futures trading. Rather, I intend to use the point spread for the Bull vs. Heat game for educational purposes, because the concept of a point spread in this basketball scenario is similar to spread trades in futures. Unquestionably, futures trading is more sophisticated, and when investing in futures and options you can lose more money than you initially invested. Further, you should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources.

So let’s look at the spread between two contracts (teams) in Heating Oil, December (the Heat) versus July (the Bulls). On March 12, 2013, the price of a December Heating Oil futures contract was 3.0631, the price of July was 3.0181. As such, the spread, or difference in price between the two contracts, was .0450.

This is a summer vs. winter spread. In Heating Oil, quite naturally, the consumption is greatest in the winter month, and as a result the market often builds a premium into the December and nearby contracts relative to other months. So in this spread a trader would buy December.

As for the short contract, July, this one tends to stay under pressure, relatively speaking, given reasonable supply. Strong demand for gasoline in the summer means that heating oil, essentially the by-product of gasoline is plentiful. More supply means that there will be lower prices, so a trader would sell July.

On March 12, the spread between December and July is at .0450. Based on our understanding of fundamental knowledge in Heating Oil, we recognize that the spread is too big and should be smaller. This is a lot like how many folks thought the Heat would beat the Bulls by more than 5 points leading them to place their money on the Heat.

Thanks to some tough defense, great shooting and superior coaching, the Bulls bullied, outworked and beat the Heat 101 to 97. So the Bulls wound up covering the spread by winning outright by 4 points.

As of March 31, the July Heating Oil contract did the same thing and outpaced the December to the downside in price, since we put our spread on.

Initially trading at 3.0631, the price of July Heating Oil dropped to 3.0280, and since we shorted July, this was a positive $1474.20 move for the spread. Conversely, we went long December, which initially traded at 3.0181 and dropped only to 3.0124 during this time period, which resulted in a $239.40 move against the spread. The spread between the two contracts narrowed to .0156 (3.0280 – 3.0124) and resulted in a successful trade to the tune of $1234.80 ($1474.20 – $239.40).

Hopefully the concept of a point spread in this basketball scenario has shed some light on how trading a futures spread can be similar. Don’t forget though that there is substantial risk of loss in trading futures and options. December did not outpace July to the downside making our trade a winner. The Heat did not outgain the Bulls on March 27, 2013, resulting in a loss for folks putting their money on the Heat and a win for the Bulls.

Go Bulls!

Additional Disclosures
STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.
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June 23, 2011 by Leave a Comment

Using Market Correlation Data to Diversify Your Portfolio

As most investors know, hundreds of strategies and ideas exist which can be used to capitalize on any market.  Undoubtedly, everyone has a different way of putting his or her money to work.  Because of the development of modern portfolio theory in the country’s best management schools, one investing behavior that every money manager encourages is diversification.  “Diversification is your ONLY friend,” does not only apply to stock picking or bond fund investing, but also applies to investing and trading futures markets as well.

While it is important to not have all of your eggs in one basket, one must be careful putting this theory into practice.  After all, how does one know what baskets are similar?  Whether referring to the diversification of long term futures holdings or markets that are day-traded, futures traders who are seeking to diversify should be looking to find markets that are as uncorrelated as possible.  Market correlations are never 100% predictable because markets tend to trade on their own metrics.  Plus, there are a lot of hidden links in the markets that surprise many new traders.  However, there are tools available that can help us determine what is correlated and not correlated over recent time periods.  This blog article will focus on how to sort through the clutter and see a couple of ways we can track this data.

Finding (non)correlations

A comparison between two markets can be positively correlated, negatively correlated or non-correlated.  Positively correlated markets tend to move in lock-step with each other.  In some cases, these positive correlations are easy to spot, like in the case of gasoline and crude oil or silver and gold.  As one market moves, the other tends to move in the same direction.  Thus, diversification would not be achieved by buying both gold and silver, or gasoline and crude oil.

Negatively correlated markets tend to move in completely opposite directions.  When one market is up the other market is down.  We see perfect examples of negatively correlated markets when looking at currency swaps.  The US Dollar and the Euro have perfectly negative correlations.  While negative correlations do offer diversification opportunities, they might not be the best strategy to employ.  A trader long the dollar and short the Euro would discover the strategy would achieve almost neutral returns due to the fact the dollar and Euro have pricing models that offset one another.  Buying and selling markets with perfectly negative correlations tend to achieve very neutral returns.  Although negatively correlated markets could offer the opportunity for futures spreading, there might be better opportunities spreading markets that are less correlated.

Please click to view the Spreads risk disclosure below.

When looking for diversification opportunities it is important to focus on markets that are non-correlated with each other.  It is best to be in positions that will profit independently.  Thus, a portfolio that has positions moving in lockstep is unnecessary.  Trading in markets that have no correlation to one another can help avoid huge account value swings and provide more focused returns.  In the new global economy though, where markets tend to be more linked than ever, non-correlated markets can be difficult to find.  Thankfully, we at Daniels Trading are equipped with tools that can do the dirty work for us.

There are two ways we could go about finding which markets move together.  First, we can simply get a charting program and overlay 2 charts on top of one another; our dt Pro platform does this very easily.  Below is an example of soybeans and silver, and how they have traded over the last 6 months.  The red line represents silver with its prices on the left axis, while the green line represents soybeans with its prices on the right axis.  We can see from viewing the chart that over the last 6 months these contracts have been slightly correlated, but not anything near a perfectly positive correlation which would sway us from investing in both markets.

Beans - Silver

Second, we can find correlations by the using the tools made available by Daniels Trading’s third party advice providers, Moore Research.  Moore Research, or MRCI as they are known, are a statistical trade research company that develops correlation studies, seasonal trade patterns and various scenario analyses.  Through their inter-market correlations research page, MRCI does the correlation research for us by providing the graph below to show us how correlated markets are over the last 180 trading days.  They even gage each commodity pair by applying numbers that measure how correlated markets are.  The higher the number the more correlated the markets are.  The closer the number is to zero the less correlated they are.  A positive number shows positive correlation, whereas a negative number shows negative correlation.  A market pair at zero would be perfectly un-correlated, while a number closer to 100 would indicate the market moves are more positively or negatively correlated.  By simply looking at this chart provided by MRCI, one can see how correlated their market of choice is to every other futures market traded.

MRCI Inter-Market Correlations

Screenshot courtesy of MRCI Online

Using the data above we can find a few markets in which to focus our attention.  Remember, we are searching for diversification, so we are looking for neutral correlations.  For example, Nick is a technical trader.  He wants to use technical analysis to trade two markets independently.  He seeks liquid markets that have little correlation.  By looking at the chart above, I would recommend he look at trading markets like the e-mini S&P and Natural Gas.  As he moves forward, he may notice correlation changes, but based on the last 180 trading days the e-min S&P and Natural Gas should provide the market action that he is looking for.  There may be better markets fundamentally or technically, but in this case Nick wants to make sure his markets of choice don’t move in lock step with each other.

Any modern portfolio theory promotes the value of diversification to help hedge market-wide risk.  To put this type of theory into action, one needs to know how each market reacts to another.  We at Daniels Trading offer the tools to help traders does just that.  For any questions on how you can diversify or use the tools MRCI offers, please contact your Daniels Trading broker.

For more information on MRCI please visit the 3rd party trading advice section of the Daniels Trading website or call Daniels Trading at 1-800-800-3840.

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 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.

Filed Under: Spreads, Strategies Tagged With: , , , , , ,
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: , , , , ,
January 28, 2011 by 1 Comment

Seasonal Futures Spread Trading

Seasonal futures spread trading is one of the best futures trading strategies that most futures traders have never heard of or just don’t know much about.  Sometimes people see “spread trading” and automatically think about options or currency trading.  Seasonal futures spread trading has nothing to do with options or spot Forex, and if you’ve found this article looking of options strategies, you’ve come to the wrong place.  However, if you are interested in a classic, time tested trading style that is used routinely by commercial and professional traders, this is the place to be.

What is a Futures Spread?

Futures spread trading is when a trader is long one futures contract and simultaneously shorts another.  This is also known as pairs trading.  Again, we are talking about futures contracts, not options.  When traders spread futures contracts, they are only interested in the change in the relative value between the two contracts.  The beauty of this concept is the position has limited exposure to external market forces like Fed Interest Rate announcements, stock market crashes, international incidents or natural disasters.  If you are tired of being stopped out of a position because of an unrelated event occurs half way around the world, you’ve found your solution.  In other words, futures spreads helps reduce systematic risk, which you can learn more about here: Hedging Systematic Risk.  This allows the trader to implement a trading strategy and not have to worry about a market crash because some small European country is going to default on their debt, which had nothing to do with the trade or investment in the first place.

Spread Trading Example

For example, let’s say it is 2007 and you are long Goldman Sachs stock.  You are unsure of the state of the financial system.  However, you think Goldman is the best bank on The Street.  You also think that Bear Stearns is the worst bank on Wall Street.  You can be long Goldman, but if the banking system collapses, it does not matter that Goldman is the best bank in town, the common stock price will decline with the rest of the market.  You could also just short Bear Stearns, but if the financial system stabilizes and the economy improves, you will lose as Bear goes up with the rest of the market.

Suddenly, you have an epiphany!  If you are long Goldman Sachs and short Bear Stearns, it should not matter if the market crashes or has a great bull run.  If business conditions are poor, Goldman should fair better since it has a stronger business.  If business conditions are favorable, you expect Goldman to get more of the business opportunities than Bear.  Regardless if the market goes up or down, the price of Goldman should outperform the price of Bear.  It does not matter what the outside markets are doing, it all just depends on the performance between Goldman and Bear.  Your trading possibilities just became endless.

(Full Disclosure – I was employed by Goldman Sachs from 2000 to 2007 and regularly used this spread trade strategy when employees were in a lock-out period for Goldman stock when we reported quarterly earnings)

The problem with pairs trading in stocks (pairs trading is another name for spread trading) is that stock is not easy to short, you have to pay interest on the shares you borrow, and if you are short stock during a dividend, you have to pay the dividend out of you own pocket to the investor you originally sold the shares to.  It gets very complicated if you are not completely on top of how shorting stock works, it can do you more harm than good.

The Solution is Futures Spreads

Luckily, shorting futures contracts carries none of the mentioned complications that occur when shorting stock.  It is just as easy being long a futures contract as it is being short a futures contract, you don’t pay interest on the short position in futures like you do in the equity markets, and there are no dividends you need to pay or worry about in commodity futures.  Spread trading in futures is much easier to execute and more efficient with capital and trading costs.

Professional traders know this, and that is why so many of them spread trade futures contracts.  There are many philosophies and methods for futures spreads, but if you are new to futures spreads and want to seriously try to learn about them, then the first thing you need to study is seasonal spreads.  Seasonal futures spreads are some of the most effective trading spreads strategies you will find, they are easier to understand, and it will create the base of knowledge to explore other kinds of futures spread trading.

Seasonal Futures Spreads

Seasonal patterns occur frequently in the commodity and futures markets.  Grains tend to trade highest in the late spring and early summer because that is when the crops in the ground are the most vulnerable to weather conditions.  Is this always the case? No, there could be years when there is no weather or growing issues and prices could decrease.  However, many years there are weather or growing concerns and it can build weather premium into the crop prices.  While the market generally prices in these weather premiums each year, there is still room for these expectation to come to fruition because the weather and crop conditions will either be better or worse than was originally expected, and that is where the opportunity lies.  Most commodities experience a natural cycle of supply and demand during the year, which can lead to natural cycles in higher and lower prices because of the seasonality of supply and demand.

Seasonal Futures Spread Example

For our seasonal example, let’s look at the Lean Hogs market.  Lean Hogs production typically peaks in early December, a few weeks before the holidays, and then has a seasonal decline until the spring when pork demand rises again for the summer cookout season.

To take advantage of this seasonal trend, we would sell February Hogs, which is the front month for when the seasonal decline begins.  We would also buy June Hogs, which should hold its value better because of the expected increased demand in late spring and summer.  If we expect prices to be weaker for Hogs in December and January, you want to be short the February contract.  If we also expect the prices for Hogs to hold their value for the spring and summer high season, we want to be long the June Contract.

We can even go back and look at how this spread trade has performed historically.  In the past 15 years, if you entered this spread in the beginning of December and exited in the second week of January, it would have been a winner or scratch trade 15 out of the past 15 years.  The average profit over that time was about $800 per spread.  Now, it might not work every year, and there is always risk in any trade, but you have to like those odds over the long haul. 

Below is a chart of the spread this year.  In the beginning of December, the spread was trading about -13.000 (meaning that Feb 11 Hogs were trading at a 13.00 pt discount to June Hogs).  February Hogs were trading at 76 cents per pound and June Hogs were trading at 89 cents per pound.  89 cents (June) – 76 cents (February) is how we come up with 13.000 cents difference in the spread between the two contract.

If the seasonal pattern holds true, we would expect the spread between the two to widen as February continues to have selling pressure while June has buying support.  By the second week in January, the spread was trading at about -14.500.  Feb Hogs were at 81 cent per pound while June Hogs was at 95.50.  While the hog market rallied overall, June increase more than February, which is what we want to see (much like how Goldman would outperform Bear Stearns when the business conditions in banking were bullish).  The spread widened, meaning June Hogs appreciated over Feb Hogs, to -14.50 cents.  The spread widened by 1.5 pts, or $600 (each full pt in Lean Hogs is worth $400).  Not quite the 15 year average of $800, but we will take it!

While this trade ended up being a winner, there is always risk.  Notice that this position was not a winner the entire time of the trade.  Towards the end of December the spread narrowed to -12.25, which would have put the position down $300 at its lowest point.

February 2011 vs June 2011 – Lean Hogs Futures Scpread Chart

February 2011 vs June 2011 - Lean Hogs Scpread Chart

Click to View Larger Spread Chart

Why Seasonal Spreads Work

As you can see, contract months in the same commodity can widen and narrow materially.  These moves are what allow us to take advantage of seasonal opportunities (it also presents risks of loss too!).  The best part about seasonal spreads is we can review different markets that have well known seasonality trends.  We know what the historical risks are, the historical performance, and we can be confident that our trades are well thought out with defined risk and reward parameters.

Learn More About Seasonal Trading

If you would like to learn more about seasonal spread trading, please register for a complimentary subscription to my Turner’s Take Newsletter.  You can also read a previous article I wrote called The Wonderful World of Futures Spread Trading.  In my Turner’s Take Newsletter, we review the commodity markets once a week and look for futures spread trading opportunities.  Not only do we look for spread trades, we also explain the seasonality, why the trade should work, and provide as much education as possible for our readers to feel comfortable and confident using this great trading strategy.

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: , , , , , ,
January 7, 2011 by 2 Comments

Futures Spread Trading: The Anatomy of a Classic Corn-Wheat Spread!

Why do some traders prefer to spread trade versus trading outright futures contracts?

The contracts often selected by the trader may be typically trading parallel to one another giving the trader only the “differential” moves between the two contracts.

One may take any two markets that they observe have differentials between the price movement and take advantage of that spread!

They may be legged in or put on as a spread trade (often with a reduced margin required for the spread).

Often, traders may think that the risk is less than an outright future.  This is a misconception! The spread trades are no less risky than an outright futures position.  In fact, typically, you may watch it closely, but cannot put a stop-loss on a spread position.

While technical entries may be difficult in outright futures, the spreads may move in sync with some fundamental factors that may reoccur at certain times of the year that affect the movement of the markets.

What types of spreads are used in commodity futures spread trading?

Intracommodity Spread or Calendar Spread

The Intracommodity Spread may also be regarded as a Calendar Spread whereby one would take the same commodity and trade two separate months against one another.  An example would be the the Natural Gas spreads where a trader may want to buy a further out month and sell a nearby month reasoning that the demand from the season may create a need to buy the future month as storage may become depleted.  These work well with grain markets as their carrying charges and seasonal tendencies may create that differential between two months.  They may also be used strategically in the meat complex as producers may take their product to market.  There are many more examples to go through, but this is not a report on calendar spreads specifically.

Intermarket Spread

The Intermarket Spread is a spread trade where one commodity may be spread against another from two exchanges.  An example may be where the Kansas City Board of Trade Wheat may be bought and the Chicago Board of Trade Wheat may be sold in consideration of a potential higher demand of a hard red winter wheat as used for breads and pastries as opposed to the soft red winter wheat typically used in cakes.  This particular spread is one that is not able to take advantage of any margin reductions usually.

Commodity Product Spread

Commodity Product Spreads require more than two contracts of commodities to efficiently hedge or fulfill a specific need in the production of raw materials.  Examples may be the Soybean Crush and the Energy Crack Spread.  These are a bit more complicated, so I will defer this subject matter to a later report.

Intercommodity Spread

The Intercommodity Spread is a spread between two different commodities, but in the same delivery month.  Often this spread will set-up according to seasonality or occasionally a harvest supply/demand picture.

The Corn-Wheat Spread

The Intercommodity Spread is our focus for today!  Specifically, we will analyze the merits of the Corn-Wheat Spread going into the 1st and 2nd quarter of 2011.  This is a trade that I have monitored since the 80’s.  I believe that it was first notable in the mid 60’s.  The beauty of taking a classic trade and reviewing the trends and history of the trade saves time in research and previous observations may even save money on potential variances to watch for.  In this particular spread, we note that July may be a strong month for corn as the weather conditions, plantings acreage, export numbers may still be unknown.  The crop is still vulnerable until toward harvest which is in the fall.  On the other hand, the harvest for the soft red winter wheat may be in July, allowing the market to regard the saturation of a harvested crop.  One may look at the months; March, July and September contracts for this particular spread trade and select another, but this is the anatomy of the spread, not to be confused with a trade recommendation.  As a matter of fact, this spread may be reversed at another time of the year.  June may be a time frame to review the Wheat-Corn Spread.  These grains are both feed product and may also be affected by livestock production trends, global supply-demand figures, weather conditions and basis for the farmer.  The wheat is typically a heavier protein cereal, while corn does not vary to the extreme.  In modern times patents on the seeds of varied grains has become big business.  The USDA regulates the delivery, grades and contract size regular for delivery.  The seeds and fertilizers must also endure disease and pests.  There are Government Subsidy programs as well in some cases to control the crops being planted.  In recent times, Africa has been know to lease land for crops to fulfill some of their required grain inventories in countries such as China.

Technically, it is good to pull up a spread chart to monitor the merit of the potential move.  One may select their Indicators to best confirm an entry.

Weekly Gold Chart

Click to View a Larger Corn-Wheat Spread Chart

In this particular spread chart, the spread may be poised to widen.  That would be the anticipated move of the Corn would rise while the anticipated move of the Wheat may be lower.

The Sample Order would be as follows:

Buy 1 ZCZ11; while simultaneously Sell 1 ZWZ11 at market! One may simply subtract the two commodity prices to establish what the spread is trading at.

Note: One must analyze the potential risk suitable for them and monitor this trade closely.  It is suggested to exit the trade immediately once it penetrates the risk parameter.  If profitable, it is suggested also to monitor the trade closely and potentially exit the trade by the 4th of July perhaps.

This may also be transposed into an options trade!

If you are a new trader, it is highly suggested that you work with your broker on the spread trades that you may have interest in.  You must consider the commission and fees in strategizing any trade, but also note the value that a broker may have on the anatomy of a spread trade for you!

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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, Technical Analysis Tagged With: , , , , , , ,