three little spreads went to market

8/18/2019 Three Little Spreads Went to Market

1/17

GUY BOWER


2/17

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3/17

INTRO

“May you live in interesting times”

This ancient Chinese curse is wheeled out every time the stock market sees a bit of volatility. If it

is applicable to the stock market, then it’s never been more applicable to the action we have seenin 2008 and 2009.

What makes it interesting is not so much that the stock market suffered massive falls or that

people, unfortunately, lost money in stocks and property, but interest in commodity markets

pushed to a new high.

The offshoot has been many people are now looking past the traditional asset classes of property

and equities. People are now looking at alternatives that provide diversification, liquidity and of

course the opportunity to profit.

As a professional trader, I see impact in the market. My ‘little niche’ is growing and I personally

think it’s fantastic. I first started learning about futures about 20 years ago thanks to a high school

excursion to the Sydney Futures Exchange. Since then I have been hooked. I have since been

involved in futures and/or options for most of those 20 years.

In the last few years, and more so in the last year, I have seen a growing interest in commodity

trading. It’s exciting to see and I encourage everyone to have a good look at the opportunities.

That is what this eBook is about. I’m introducing three relatively straight forward strategies. They

are all what you call “spreads”. That is, they involve buying one futures contract and sellinganother to profit from a change in the price differential.

Spread trading is very much a niche, but as this eBook will show you, it can provide some fantastic

trading opportunities. I will show you three little strategies that professional traders use and few

others know.

Yes, there is some jargon and yes, some concepts may make you scratch your head, but please

persist. These strategies are not as complex as they first may seem. We are not talking rocket

science or complex mathematics here. The mathematics involves addition and subtraction.

So let’s get on with it. First of all, I have put together what I call a mini ‐glossary. These terms are

particularly relevant to the following discussion. Then we look at the three spread strategies: the

bull spread, the bear spread and the inter ‐market spread. This is the guts of this eBook. Then we

look at where to get more info on how to trade spreads.

This eBook is aimed at a beginner level. However, some knowledge of futures trading would be

advantageous.


4/17

SUMMARY

An e-book for beginners, Guy Bower introduces three relatively straight forward strategies for

spread trading -- buying one futures contract and selling another to profit from a change in the

price differential.

While spread trading is very much a niche, this eBook will illustrate that this method can provide

some fantastic trading opportunities. Guy shows you three little strategies that professional traders

use and few others know. There is also a mini glossary included relevant to the discussion of the

strategies.

BIO

Guy Bower has worked in financial markets for nearly 20 years. As an analyst, broker, director of amanaged-futures fund, and CEO of a stock brokerage and funds management business, Guy

learned his trade from the bottom up. Not satisfied simply to “work” in the financial markets, Guy

developed and utilized his entrepreneurial side to both advance his knowledge to a new and higher

level and deliver that knowledge through quality services. Building upon the foundation developed

from his years of work in the financial industry, he started and built a commodities broker business

and trading advisory service that has served countless traders. As an author, he continues to

deliver his hard-earned knowledge to traders of every stripe. Currently, as the Publisher of the PTD

newsletter (www.ProTradeDigest.com), and a contributor to TraderPlanet.com, a dynamic and

interactive website dedicated to educating traders, Guy uses his research, knowledge, andexperience to identify spread-trading opportunities in the market, and to make those opportunities

available to his readers.


5/17

Three Little Spreads Went To Market GuyBower.com Page 2

Contents

1. Introduction 3 2. Mini‐Glossary 4 3. Strategy #1: The Bull Spread 6 4. Strategy #2: The Bear Spread 8 5. Strategy #3: The Inter ‐Commodity Spread 10 6. Summation 12 7. About the Author 13 8. Web Resources 13

Acknowledgements

The charts in this eBook are kindly provided by eSignal . Over the years, I have usedmany different systems. One I have kept is eSignal. I absolutely love it. Thanks toMina Delgado and all at eSignal for their ongoing support.

Thanks also to Daniels Trading who provided some of the data and technicalassistance.

Legal InformationFutures trading involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Information here is taken from sources believed to be reliable. We do not guarantee that such information is accurate orcomplete and it should not be relied upon as such. There is no guarantee that the information given here will result in profitable trades. Only youcan take responsibility for your trading decisions. This document is meant as education, not advice.© Copyright 2009 Guy Bow er. All Rights Reserved.

ProTrader LLC. 244 5th Avenue #2741. New York, NY 10001

http://www.esignal.com/http://www.danielstrading.com/http://www.danielstrading.com/http://www.esignal.com/


6/17


INTRODUCTION by Guy Bower

“May you live in interesting times”

This ancient Chinese curse is wheeled out every time the stock market sees a bit of volatility. If it is applicable to the stock market, then it’s never been more applicable to the action we have seen in 2008 and 2009.

What makes it interesting is not so much that the stock market suffered massive falls or that people, unfortunately, lost money in stocks and property, but interest in commodity markets pushed to a new high.

The offshoot has been many people are now looking past the traditional asset classes of property and equities. People are now looking at alternatives that provide diversification, liquidity and of

course the opportunity to profit.

As a professional trader, I see impact in the market. My ‘little niche’ is growing and I personally think it’s fantastic. I first started learning about futures about 20 years ago thanks to a high school excursion to the Sydney Futures Exchange. Since then I have been hooked. I have since been involved in futures and/or options for most of those 20 years.

In the

last

few

years,

and

more

so

in

the

last

year,

I

have seen a growing interest in commodity trading. It’s exciting to see and I encourage everyone to hav e a good look at the opportunities.

That is what this eBook is about. I’m introducing three relatively straight forward strategies. They are all what you call “spreads”. That is, they involve buying one futures contract and selling another to profit from a change in the price differential.

Spread trading is very much a niche, but as this eBook will show you, it can provide some fantastic trading opportunities. I will show you three little strategies that professional traders use and few others know.

Yes, there is some jargon and yes, some concepts may make you scratch your head, but please persist. These strategies are not as complex as they first may seem. We are not talking rocket science or complex mathematics here. The mathematics involves addition and subtraction.

So let’s get on with it. First of all, I have put together what I call a mini‐glossary. These terms are particularly relevant to the following discussion. Then we look at the three spread strategies: the bull spread, the bear spread and the inter ‐market spread. This is the guts of this eBook. Then we look at where to get more info on how to trade spreads.

This eBook

is

aimed

at

a be ginner

level.

However,

some

knowledge

of

futures

trading

would

be

advantageous.

“People are now looking at alternatives that provide diversification,liquidity and of course

the opportunity to profit.”


7/17


MINI‐GLOSSARY

Futures Contract

A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given commodity [or asset] at a specific delivery location and time in the future. All terms of the contract are standardized except for the price, which is discovered via the supply (offers) and the demand (bids). This price discovery process occurs through an exchange’s electronic trading system or by open auction on the trading floor of a regulated commodity exchange.

All contracts are ultimately settled either through liquidation by an offsetting transaction (a purchase after an initial sale or a sale after an initial purchase) or by delivery of the actual physical commodity. An offsetting transaction is the more frequently used method to settle a futures

contract. Delivery

usually

occurs

in

less

than

2 percent

of

all

agricultural

contracts

traded.

Source: CME

Long position Buying a futures contract with a view of it increasing in price means you have a long position or are “long the market”.

Bullish A bullish view means you expect the market price to go up.

Short position Selling a futures contract before you buy it is called going short or short selling. This concept often confuses the newcomer as the reflex thought is “How can you sell something you don’t own?”

The key to getting your head around this one is to remember futures contracts are simply agreements or bets on future price, and are generally not entered with a view of delivering or taking delivery of the physical commodity.

To enter

a short

position,

you

place

an

order

to

sell

the

futures

contract

or

contracts.

To

close

the

position, you place an order to buy the contract(s) back.

Bearish A bearish view means you expect the market price to go down.

Expiry or Delivery mont h All futures contracts have a finite life. That is, there is some point in the future where they cease to trade. An exchange will make available a number of expiry months depending on demand for trading.


8/17


Some contracts call for physical delivery, some call for cash settlement, but very few people keep trading until the expiry date. Most contracts are closed out beforehand, so actual delivery or physical settlement is rare.

Margin When you enter into a futures contract, you do not need to pay the entire contract value. Instead you are charged a deposit or “margin”. This margin varies depending on the particular contract. Margin rates tend to be a small fraction of the total contract value.

Futures Broker To trade in futures contracts you need a futures broker. Some stock brokers may have futures trading departments but there are also many brokers that offer futures trading only.

Spread In the context of this eBook, a spread is the simultaneous purchase (long) of one contract and sale of another (short) with a view of profiting from a change in the price differential.

To qualify as a spread, the contracts have to be related. For example, you could take on a spread position by buying (going long) wheat and selling (going short) corn.


9/17


STRATEGY #1: The Bull Spread

The bull spread consists of two futures contracts – one long (bought) and one short (sold). To create

a bull

spread,

a trader

would

buy

the

nearer

to

expiry

contract

and

sell

short

the

distant

contract.

Some examples of bull spreads are:

Long (bought) Contract Short (sold) Contract

July 2010 Soybeans September 2010 Soybeans

October 2009 Natural Gas November 2009 Natural Gas

September 2009 Corn December 2009 Corn

Generally speaking, a bull spread is a bullish position. That is, the spread is a strategy a trader would place when he/she is bullish on the market.

What Makes it a Bullish Position?

The answer to this one is very simple. When a market rallies, it is normally the nearer contract that leads the way. That is, the contract that is closer to expiry tends to move further than the more distant contract. So buying the nearer contract and selling the more distant contract is a bullish strategy.

As an example, let’s have a look at Soybean Meal over the early part of 2009. The chart on the next page shows the price for December Soybean Meal and the bull spread price of Dec 2009 less July 2010 Soybean Meal.

You can see a bull market occurred in both Soybean Meal futures and the bull spread around same time.

In the market, traders can use the spread as an alternative to trading a single futures position. There are several reasons why a spread may be preferred:

Significantly lower margins. That is, it costs less to place the trade.

Reversals in spreads can often precede reversals in the underlying market. That is, the spread can act as an early warning indicator. This is evident in the chart above. If you look closely at points 1 and 2, you’ll see the spread starting and finishing its bull run before the same move in the futures contract, made a move higher (point 1) and completed the rally (point 2) before the futures.

Lower volatility. Generally speaking, a spread will carry less volatility or risk than trading outright futures. This can make spreads more attractive to the newcomer or conservative trader.


10/17


Diversification. Lower margins means the trader can spread risk across more trading positions than would be possible when trading outright contracts.

When is a Bull Spread Not a Bullish Spread?

There are times when the underlying market may rally and the spread does not move in the same direction. The scenarios in which this can happen do vary from market to market.

However, as a general statement it is more often news or fundamental supply information that will push a bull spread higher whereas a technical or speculator ‐led rally may not see the spread move in the same direction as the underlying futures.

While this concept may at first seem complex, it’s simply a matter of knowing what is driving a certain market. All that is needed here is a good source of trading information and market news.


11/17


STRATEGY #2: The Bear Spread

Like the bull spread, the bear spread consists of two futures contracts – one long (bought) and one

short (sold).

To

create

a bear

spread,

a trader

would

sell

short

the

nearer

to

expiry

contract

and

buy

the distant contract.

Some examples of bear spreads are:

Short (sold) Contract Long (bought) Contract

July 2010 Soybeans September 2010 Soybeans

October 2009 Natural Gas November 2009 Natural Gas

September 2009 Corn December 2009 Corn

You can see the bear spread is simply the reverse of the bull spread. It stands to reason that a bear spread is a bearish position. That is, the spread is a strategy a trader would place when he/she is bearish on the market.

As with a rallying market, when a market is in a bear trend, the nearer contract tends to lead the way. As such a bear spread is an alternative to an outright short position.

Just like the bull spread, trader can prefer a bear spread in a bear market for reasons of lower margins, lower risk, better diversification potential and the fact a spread can signal a turn in the underlying market ahead of time.

So let’s look at an example. The following page shows the same Soybean Meal chart as that in the bull spread example. Note the spread is plotted as Dec (near) less July (far). With the bear spread, being short the Dec (near) and long the July (far) contracts, the trader would want to see this spread fall to make a profit.

The thing to see in this chart is the fall in the spread as the outright December contract falls, as shown by the two arrows.

A Word on Margins

As mentioned earlier, one reason traders like to trade spreads is the lower margin requirements. In the Soymeal example, a margin for an outright futures contract would be $2000. For the above spread, it would be 10 percent of that, or $200. That’s a big difference.

Now while the spread has less volatility than the futures contract, the spread still gives you far more bang for your buck. Of course that can work for you or against you depending on what the market does, but it remains an attractive feature of spread trading.


12/17


Great Markets for Trading Bull and Bear Spreads

This list is based on experience and general opinion. There may well be markets not listed here that offer good spread trading opportunity.

Energies: Crude Oil, Heating Oil, Natural Gas

Grains: Wheat, Corn, Soybeans, Soybean Oil, Soybean Meal

Metals:

Copper

Food & Fibre: Cocoa, Coffee, Sugar

Financials: Eurodollars, T‐bonds, T‐notes

Livestock: Feeder Cattle, Live Cattle, Lean Hogs


13/17


STRATEGY #3: The Inter ‐Commodity Spread

Our third type of spread is an inter ‐commodity spread. It is a spread between two different but

related markets.

Consider markets such as Wheat futures and Corn futures (below). They are similar commodities (being grains) and the prices are related. A move in one market can move the other, but the y do not move one for one. This creates spread trading opportunities.

Consider another two markets: Live Cattle futures and Lean Hog futures (below). Both are livestock bred for human consumption. Both futures markets can move in line, but they can also have unique influences. This creates spread trading opportunities.

Another example is Silver and Gold (not pictured). Both are precious metals and as such tend to

move in

line

with

each

other.

But

there

are

also

influences

that

are

unique

to

each

market.

This

creates spread trading opportunities.


14/17


There are essentially three types of inter ‐commodity spreads:

1. Spreads between

related

commodities.

All

examples

above

fall

under

this

category.

2. Spreads between a commodity and its derivatives. An example is Soybeans versus Soybean Oil and Soybean Meal. The Oil and Meal is derived from Soybeans. Another example is Crude Oil versus Heating Oil or Unleaded Gas. Heating Oil and Gas is derived from Crude.

3. The third type of inter ‐commodity spread is spreading the derivatives as outlined above. An example is Soy Oil versus Soy Meal, or Heating Oil versus Unleaded Gas. The prices of these contracts are related but the relationship does vary and therefore spread trading opportunities exist.

So let’s look at an example. One spread I enjoy trading is Live Cattle versus Lean Hogs. As mentioned above, both are livestock bred for human consumption.

On one hand they are interchangeable foods. If the price of pork chops is too high, you may buy beef steaks instead for example. However, there are also some differences. Pork, for example, is used to make processed meats. These pork products have different demand characteristics from beef products.

As such, we have two related but different futures contracts. Therein lies the trading opportunity. For example, during the US summer holiday and driving season, demand for processed meats picks

up relative

to

beef

products.

Conversely,

during

winter,

demand

for

beef

products

tends

to

be

stronger.

It’s the shift in relative demand (or supply) that creates a seasonal variation in the spread price. Generally speaking, the futures contracts will start pricing in these end ‐product demand patterns well ahead of time, but with a well timed ‐trade, it is possible to make money from these patterns.

Facts About Inter ‐Commodity Spreads:

Inter ‐commodity spreads tend to be a little more risky than the kind of bull and bear spreads we looked at earlier.

Margins are still less than outright futures margins, but more than bull/bear spread margins.

There is generally more profit potential from an inter ‐commodity spreads than a bull or bear spread. This is not always the case, but it is more often than not.


15/17


Great Markets for Trading Inter ‐Commodity Spreads

Metals: Gold‐Silver

Financial Spreads: Combinations of 5yr note, 10yr note and 30yr bond.

Grains: Combinations of Wheat, Corn and Soybeans Soybeans Crush (Soybeans, Soy Oil and Soy Meal)

Livestock: Combinations of Feeder Cattle, Live Cattle, Lean Hogs

Energy Markets: Crack Spreads (Crude, Heating Oil, Unleaded Gas)

SUMMATION

This eBook presented three spread trading strategies. These are popular strategies among many professional and veteran traders.

Despite the low risk profile relative to trading outright futures, very few newcomers know of these strategies. The global financial crisis however is driving change. Private traders are starting to look beyond the equity and property investments and focus on opportunity instead of tradition.

This is where spread trading can come alive. Spread trading offers some great opportunity and I hope this short eBook will whet the appetite of some new traders out there.


16/17


ABOUT THE AUTHOR

Guy Bower has been involved in the financial markets for

nearly 20 years. He has worked as an analyst, broker, authorand was a director of a managed futures fund. He has startedand owned a commodity broking business and tradingadvisory service. He has also been a CEO of a stock brokerand funds management business.

As the Publisher of the PTD newsletter ( www.ProTradeDigest.com ), Guy uses hisresearch, knowledge and experience to identify spread trading opportunities in themarket.

He may be reached at [email protected].

http://www.protradedigest.com/http://www.protradedigest.com/


17/17

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three little spreads went to market

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