Introduction to Spread

Trading
presented by Jay Richards

Trading with a Built-in (H)edge

www.justspreads.com.au
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 What is Spread Trading?

Spread Trading is when you buy a futures

contract and sell a related futures contract at
the same time.

When you do this you are trading the difference

or spread price between the two contracts.

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 What is Spread Trading?

By combining a long and a short position you

create an entirely new trading entity/contract.
- one contract can have multiple combos
- different fundamentals at work
- indifferent (usually) to the direction of the underlying

The new spread has the same charting

characteristics as an outright contract with an
Open, High, Low and Settlement price.

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 What is Spread Trading?

The new spread has the same charting

characteristics... Why is this important?

Everyone here is a chartist or a technician of

price movement!

- finer more accurate detail

- chart analysis
- identify patterns i.e. continuation, reversal, consolidation
- apply technical studies

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 Composite of a Spread Chart
December 2010 corn price is 4.88
July 2011 corn price is 5.09
The price differential or spread price is 4.88 minus 5.09 = -.21
Spread Chart of December 2010 Corn/July 2011 Corn
 Types of Futures Spreads

Intra-market or calendar spreads: identical

contracts with different expiration times. e.g.
long December 2010 and short July 2011 Corn

Inter-market spreads: closely related

contracts but with identical expiration times.
e.g. long August Live Cattle and short August
Lean Hogs

Inter-exchange spreads: related contracts at

different exchanges. e.g. long July Wheat at
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CBOT and short July Wheat at KCBOT
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 Futures Spreads Terminology
Spreads are either positive or negative.

The front leg determines this by either being higher or

lower in price to the deferred leg.

Its simple math but important to know the terminology.

If you buy AUG Cattle (108.925) and sell AUG Hogs

(94.825) you will want to see the spread price widen.

If you buy JULY CBOT Wheat (6.70) and sell JULY

KCBOT (7.910) Wheat you will want to see the spread
price narrow.
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 Benefits of Spread Trading

Reduced volatility spreads are a

natural hedge and have less risk than an
outright position.
Remember the 6% drop overnight in the Nikkei?

Reduced margins which means

that you can afford to hold multiple
spread positions. e.g. Heating Oil margin
outright - $5063 calendar spread - $550
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 Benefits of Spread Trading

Outright margins / Spread margins

Live Cattle $1620 $338

Corn $2363 $270 - $810

Soybean Oil $1688 $101

Crude Oil $8500 $405 - $1215

Copper $5800 $304

Cocoa $2730 $404 13

 Benefits of Spread Trading

Position trader as a trend trader (in

spreads) you inherently become a
position trader.
The most successful traders in history are position traders:

Warren Buffett

George Soros

Ralph Nelson Elliott

W.D. Gann

John Moulton (Rambo) 16

 Benefits of Spread Trading

True market activity majority of

spreads are not held to the influence of
large commercial involvement as with an
outright and are less concerned with
liquidity and slippage.

A natural trend will evolve from the merits

of the spread combination you have selected.

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 Benefits of Spread Trading

Trending nature - spreads trend more

often than outrights, in fact spreads can trend even
while the underlying futures are moving sideways.

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 Benefits of Spread Trading

Seasonal spread pattern is the

tendency for a particular spread to
behave (price wise) during a certain
calendar period every year.

The monthly chart below ranges from 1995 till April

2011. Close examination will show the seasonal
tendencies for this spread to widen during the
suggested time frame of early May through the end
of June.

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 Benefits of Spread Trading

Greater anticipation you can plan

spreads several days in advance and do
not need a technical indicator such as a
stochastic or MACD to trigger you into
the trade.

If I had eight hours to chop down a tree, Id spend six hours

sharpening my axe. - Abraham Lincoln

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 Non-Seasonal Spread Trade

Some spreads can be traded without a

seasonal but you can still create an expectation
and anticipate the trade.

Example is a recent STO (Spread Trade

Opportunity) traded in the Just Spreads MDA.

Sell Dec 11 / Buy June 12 Eurodollar (interest rate)

Sold at .2175 and bought at .14 using the price

projection method based on swing highs to
swing low measurement.
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 Seasonal Spread Trade

Some spreads can be traded with a seasonal

but you still need a trigger beyond just an entry
and exit. This gives you a greater point of
control.
Example is a recent STO traded in the Just
Spreads MDA; Seasonal is Nov 23 Feb 11

Sell Mar 12 / Buy May 12 Wheat (CBOT)

Sold at -15.0 and bought at -22 using a

settlement gap as an initial price/profit
objective.
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 Discover Your Comfort Zone

Set achievable goals for financial gain

Write down your financial goals

Establish time frames for each goal

Do not trade with any money you cannot

afford to lose

An investment in knowledge always pays the best interest.

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 Discover Your Comfort Zone

Discover your comfort zone

Two types of participants:

- traders looking to improve
- those wanting to become a trader or a more active investor

Be honest with yourself and be patient with the markets... wait

for your bus

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 Discover Your Comfort Zone

Pick five contracts that are within your

comfort zone based on your risk tolerance:

- Grain contracts; soy meal/oil, wheat or corn

- Meats; lean hogs or live cattle
- Softs contracts; cocoa or coffee
- Metal contract; copper (spreads)
- Energy contract; heating oil or crude oil

All have low margin, low volatility, a trending nature

(range from a high to a low) and allow a greater use of
your trading capital.
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 Build a Trading Mentality

Be prepared and always a student

Self-determined
Best fit scenario an hour per day

Simulate trade scenarios (paper trades), stay involved

through seminars, trading groups and study

Understand a range of markets and their fundamentals

Charts, data and getting behind the wheel

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 Build a Trading Mentality

Develop your trading style what works for one trader

does not necessarily work for another

Three key points to consider:

- The most successful traders are trend-traders

- Decide if you will be a day or position trader
- Determine your understanding of success

Our lives improve when we take chances and the first and
most difficult risk we can take is to be honest with ourselves

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 Build a Trading Mentality

Trading Pitfalls:

1. Failure to have a trading plan

2. Improper money (trade) management

3. Unrealistic expectations

4. Failure to use STOPS

5. Lack of discipline is a lack of faith in your

decision- making process

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 Build a Trading Mentality

6. Trading against the trend or trying to pick tops

and bottoms

7. Holding losing positions too long

8. Over trading

9. Failure to accept responsibility for your own

trading decision

10. Not keeping perspective

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 Psychology of Trading

Put yourself in the role as a trader stay

within your comfort zone

Allow trading to be a Zen Thing

Clear your mind of greed and fear

Practice healthy routines

The difference between a rut and a groove is attitude

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 Psychology of Trading

Try to improve yourself everyday and enjoy the

journey. Practice your craft and dont focus too
much on profit or losses.

Allow yourself to feel good regardless of profit

or loss, so long as you acted to your plan.

Listen to the market. Think about where your

head is at during a trade and consciously
develop the zone that allows you to trade well.

Do the right thing regardless of what others think

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 Psychology of Trading

Winning and your ego can create powerful

emotions that distort reality. The more you win
the better you feel and your ego takes over.

The joy of winning is what gamblers seek.

A gambler will lose as many times as necessary
just for the thrill of winning once.

Research, learning and the preparation for taking

a trade takes much longer than executing and
watching a trade.

Be ruthlessly realistic when it comes to your finances

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 Money Management

Money management is the most important aspect

for successful futures trading.

Although your decision-making process or basis

for taking a trade can be sound, it is your money
management that will make or break you.

You will have a higher number of losing trades to

winning trades. Successful traders know this.

A few winning trades will outperform all the

small losses.

Accept the fact that regardless of how many times you might
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be right, you will sometimes be wrong
 Money Management

A trading plan is all about mapping out your

expectation - how and when to enter and exit
a trade before you take the trade.

You must create an expectation and believe

in your work. You must have faith in your
decision-making process.

Know precisely how much money you can

afford to lose and use your stop.

Go with the trend. Buy strength and sell weakness.

Tell me once and Ill forget; show me and I may

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remember; involve me and Ill understand. - Confucius
 Spread Trade Opportunities

When we return from the break:

Strategies for taking the Gold/Silver spread

- Spot market in a margin account
- Futures

Pairs trading with ASX shares using CFDs

- CBA/NAB
- BHP/RIO

Trading method for entry, exit and price projection

- Live Cattle futures spread with a seasonal time frame
- Unleaded Gas spread without a seasonal time frame

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 Spread Trade Opportunities

Review of the long Gold / short Silver trade for May 2011:

As a (spread) trader we might have the view or speculate that

when gold and silver reach a ratio of around 32:1 the spread
price is too narrow (historically) and that we anticipate it should
widen out to say 38:1.

We look to sell silver the expensive commodity (as it relates

to gold) and buy gold the cheap commodity (as it relates to
silver).

To benefit financially a trader can buy gold and sell silver in

equal dollar amounts, so long as the price/ratio widens out.
Lets take a close look at the spread history of long gold and
short silver during early May through to the end of June.
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 Spread Trade Opportunities

Two strategies for taking the Gold/Silver spread

Scenario #1 - OTC trade using spot metals - 33:1 ratio
Our example is based on Gold at $1500/Silver at $45 ounce.
- Customized to your risk appetite
- Margin account lets you choose the dollar amount
- E.G. $30,000 to each leg (long gold/short silver)
- 20 ounces of gold/660 ounces of silver
- Holding cost is around $5.00/day (not including commissions)
- Requires less than $5,000
- 5 weeks later spread moves out to 37:1
- Gold is now $1400/oz; Silver is $38/oz
- We lose $2,000 on the Gold/$4700 profit in Silver
Approx profit is $2700

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 Spread Trade Opportunities

Scenario #2 Futures contracts at COMEX (Commodity Metals

Exchange in New York)

Our example is based on Gold at $1500/Silver at $45 ounce.

- Long 3 100/oz AUG Gold/short 2 5,000/oz SEP Silver

- Spread margin is excess of $17,000
- No holding charges
- 5 weeks later spread moves out to 37:1
- Gold is now $1400/oz; Silver is $38/oz
- We lose $30,000 on the Gold and profit $70,000 in Silver

Approximate profit is $40,000 USD

We look to sell silver the expensive commodity (as it relates to

gold) and buy gold the cheap commodity (as it relates to silver).
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 Spread Trade Opportunities

Timing Your Trade

Seasonality suggests that a change in direction (gold/silver) to
the upside (widens) occurs in late April or early May. The chart
below represents the last 15 years for the gold/silver spread.
The monthly spread charts below tells us that the price of silver
has outpaced the price of gold regardless of the outright
direction of either metal during this time frame.
The monthly chart below ranges from 1995 till April 2011.
Close examination will show the seasonal tendencies for this
spread to widen during the suggested time frame of early May
through the end of June.
The seasonal strategy calendar indicates that silver drops in
value during mid-May through to mid-June around 64% of time
over the last 15 years. Perhaps this is further indication that
silver might outpace gold. 43
Spread Trade Opportunities

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Spread Trade Opportunities

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 Spread Trade Opportunities

Pair #1 ANZ/WBC

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 Spread Trade Opportunities

Pair #2 RIO/BHP

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 Entry and Exit Strategies for Spreads

Swing Lines to identify specific trends

Bar Chart analysis to trigger us into/out

of trades i.e. reversals, double bottoms/tops

Price Projection based on our swing lines

for a calculated approximation for price

Seasonal statistics provide further

expectation of price behaviour during a specific
time period

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 Entry and Exit Strategies for Spreads

Swing Line Calculation for Price Objective

Recent swing high #2 is -0.75

Recent swing low #1 is -1.40

The difference is -0.65

i.e. -1.40 minus -0.75 = -0.65

By adding this (-0.65) to -1.40 we can

approximate a price objective of -2.05
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 Entry and Exit Strategies for Spreads

Swing Line Calculation for Price Objective

Swing high #3 is -1.8

Swing low #2 is -3.0

The difference is -1.2

i.e. -1.8 minus -3.0= -1.2

By adding -1.2 to -3.0 we can

approximate a price objective of -4.2
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Entry and Exit Strategies for Spreads

- bar charts improve entry/exit levels

- swing lines for trend determination

- price projection to bolster our price

expectation and maximize profit

- trade management is greatly

improved with measured expectation

A single trade made a profit of $720

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SEPTEMBER/NOVEMBER Unleaded Gas

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 SEP/NOV Unleaded Gas

Swing Line Calculation for Price Objective

Swing high is 1129

Swing low is 932

The difference is 197

i.e. 1129 minus 932= 197

By adding 197 to 1129 we create (project) a price

objective of 1326

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SEP/NOV Unleaded Gas

Review of our second example we have:

- reduced volatility of around 90%

- reduced margin of around 90%
outright margin $5,063 spread $550

- no seasonal time frame

- bar charts have double bottoms and

reversals to improve entry/exit levels
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 SEP/NOV Unleaded Gas

- swing lines clarify the trend

- price projection approximates our

price expectation and maximizes our profit

- trade management is greatly

improved with measured expectation

A single trade from our entry at 1020 to

our exit at 1326 made around $1260
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 Acknowledgements

Australian Technical Analysts Association

Aliom Financial Markets

eSignal a division of IDC

Your Trading Edge Magazine

FN Arena Financial Journal

Commodity Traders Almanac 60