Lessons from the Pros

Spread Trading – A Versatile Tool

A Futures Spread is a position in the market where you are simultaneously long and short. Think of it as a hedged position which offers protection from volatile outright Futures positions. These Spreads can be:

• Intra-Market – long and short the same market, but in different contract months
• Inter-Market – long and short, but in related markets (Notes/Bonds, Wheat/Corn, etc)

The way we profit from this trade is when the net difference between the two positions changes. Let’s take a look at a Wheat Spread.

Figure 1 shows us the closing prices of two different months of Wheat contracts. If you notice on Day 1, the difference (Spread) between the two closing prices was +.20. If we purchased this Spread on Day 1, we would like to see the Spread widen between these two contracts in order to make a profit on this trade. On Day 2, we see the market closed and the Spread did widen. We entered the trade at +.20 and now it has widened to +.35. We have profited +.15 on this particular Spread. The point value for Wheat is $50. This +.15 profit equates to a $750 profit for us. Sometimes while an outright Futures position is going sideways, these Spreads are contracting and expanding allowing us many trading opportunities.

There are many reasons for these Spreads to change price. Most of the time it is purely Supply/Demand. For example, look at Copper in the spring. The building industry is starting to ramp up their inventories of materials. This causes Demand in the March contract of Copper, while the December contract of the same year will not have the same amount of Demand because next December is not a high Demand time for Copper. The long March – short December Copper trade is a very good seasonal trade to place. Once you enter the Spread, both contract prices will most likely rise, but the March contract should outpace the December contract because of the immediate need for Copper.

Commodity markets are driven by Supply and Demand on a daily basis. The majority of the volume created each trading day is done by Commercial traders (people who either produce or process the physical Commodities themselves). This class of traders is known as the smart money in the Futures arena. Commercial traders are well-funded and know all the fundamentals of the markets they trade. They are so large that sometimes they can hold 80-85% of all the contracts on either the long or short side of a market. This leaves only 15-20% of the total Open Interest (number of outstanding Futures contracts at the end of the day) in the hands of Large and Small Speculators. By watching these Spreads you can sometimes see a tipoff to market bottoms and tops that these Commercial traders cause. Let’s review a recent example in Sugar.

Figure 2

In Figure 2 we see Sugar in a very strong bull market, and this chart only shows half of it. I kept looking left on the weekly charts trying to find a Supply level that might stop this Bull. I, for one, am not one to step in front of a train. I was watching the Spread of the May 2010 and May 2011 Sugar contracts for a clue as to when this Bull was going to lose some steam at a Supply level.

In normal markets, the price structure of all the contract months traded usually go in an ascending order. Here is a link to Moore Research Center (MRCI) showing these prices as they trade in each contract month.

http://www.mrci.com/ohlc/

Note: MRCI is still offering Online Trading Academy students a free trial of their Seasonal Spread and Futures trade reports. You can contact Melissa Moore at Melissa@mrci.com. The website is loaded with very informative, free information for Commodity traders. Keep in mind this is a research firm and not a trade recommendation website.

Look through the different Commodity sectors and notice if you see any Commodities with a different pattern – closing prices are in a descending order the further out you go. If you find a market, and there are a couple of them as of this writing, you have a perfect candidate for a Bull market starting in that Commodity.

For example, in our Sugar trade, the May 2010 contract would typically be trading at a lower price than the further out May 2011 contract. This is because Commodities have fees (storage, insurance and interest) to hold them until somebody takes delivery from them at a later time in the year. When this price structure changes and the nearby month (May 2010) is priced at a much higher price than the deferred month (May 2011), then we have a very tight supply situation and market participants are willing to pay a premium to get this Commodity right now for they fear it will not be any cheaper in the near future. Eventually, during a Bull or Bear market, the Supply/Demand equation changes and the first ones to know this will be the Commercial traders. In the case of a Bull market, they will start to sell the front months (May 2010) and buy the deferred months (May2011) thereby causing the Spread to narrow.
In Figure 2 we saw how the May 2010 Sugar contract was making new highs into late January. Below is a chart showing the Sugar Spread between the May 2010 and May 2011 contracts. Notice in Figure 3 that the Spread did not make a new high when the outright Futures contract was in late January.

Figure 3

This was the first warning sign the Bull market was ready to take a break. This combined with a weekly chart Supply level (close to a gap). Notice also the classic Double Top pattern on this Spread chart. Basically, there were three reversal signals that were waving red flags as to the exhaustion of this move. As if that was not enough, the Commercial traders held 81% of the short contracts in Sugar that week, a historically high amount.

I point this example out so you may start doing some research on these Spreads and using the analysis in your own trading of outright Futures. You will see very quickly how much of an edge you can get by understanding these Spreads.

As I mentioned previously, when a market starts to trade for a higher price in the front months than the back months, you will see the makings of a Bull market in progress. Keep in mind we are dealing with the markets here so this is not "always" the case. But the majority of time, you will see some very active price movements when this occurs.

Your question probably is, "Well, how do I see this happening?"

For starters, you can track these prices on MRCI’s website and when you start to see a change in the price structure, you can create a Spread chart of the Commodity in question. Each charting platform does this a little differently, but the results should be the same. I usually build the Spread charts using contracts that are about a year apart. While watching these Spread charts, I look for when the front month contract starts to trade for more than the back months. At this point, the Spread chart is showing the Spread crossing the Zero line to the upside. Now this does not mean to take a long position blindly. This is purely a signal that the market is in the hands of some very strong players (Commercials). Once you see this setup, you begin to use your technical analysis skills to time your entry to the long side of the market. And do I need to remind you, "Always, Always have a protective stop" in the market. Figure 4 below is the Sugar Spread we have been referring to, and watch what happened when the price crossed the Zero line.

Figure 4

Finding trades like this are the type you want to hold onto for as long as possible. These are not setups that you jump in and take a couple of ticks out of the market. These fundamental setups can give you the added confidence to hold these trades for much longer than usual as long as they are profitable.

Spread trading has so many advantages in the markets even if you do not trade them. Another reason I really like using Spreads is that the retail trader rarely even knows what a Spread is. You can bet the Commercials do and I want to be on the smart money team.

"Failure lies not in falling down. Failure lies in not getting up." Chinese Proverb

Good trading,

- Don Dawson