Introduction to Spread Trading presented by Jay Richards ‘Trading with a Built-in (H)edge’ 1.

Introduction to Introduction to Spread TradingSpread Trading

presented by Jay Richardspresented 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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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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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 ChartDecember 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 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.

It’s 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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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


• 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)

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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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• 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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• 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 endof June.

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• 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, I’d spend six hours sharpening my axe. - Abraham Lincoln 22

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 cannotafford to lose

“An investment in knowledge always pays the best interest.”

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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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Speculation is not the same as gambling

- Gambling creates risk on your money- The risk in trading already exists

Speculators stabilize markets by creatingliquidity and price efficiency

If you rely on hope you are gambling

You must be able to move on from every trade (winners and losers) so you can be prepared for your next trade opportunity.

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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’26


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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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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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 perspective29

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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Try to improve yourself everyday and enjoy the

journey. Practice your craft and don’t 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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Winning and your ego can create powerfulemotions that distort reality. The more you

winthe 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

be right, you will sometimes be wrong”

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Money Management

A trading plan is all about mapping out yourexpectation - how and when to enter and

exita 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 canafford to lose and use your stop.

Go with the trend. Buy strength and sell weakness.

“Tell me once and I’ll forget; show me and I may remember; involve me and I’ll understand”. -

Confucius

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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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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 let’s 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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Two strategies for taking the Gold/Silver spread

Scenario #2 – Futures contracts at COMEXOur 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 (approx) $30,000 on the Gold/ (approx)

$70,000 profit in Silver. Approx profit is $40,000 (less

comm)

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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Pair #1 –ANZ/WBC

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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 SpreadsSwing Line Calculation for Price Objective

Recent swing high #2 is -0.75Recent swing low #1 is -1.40

The difference is -0.65i.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 SpreadsSwing Line Calculation for Price Objective

Swing high #3 is -1.8Swing low #2 is -3.0

The difference is -1.2i.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 1129Swing low is 932

The difference is 197i.e. 1129 minus 932= 197

By adding 197 to 1129 we create (project) a price objective of 1326

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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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- 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

Just Spreads

Aliom Financial Markets

eSignal a division of IDC

Your Trading Edge

FN Arena

Commodity Traders Almanac 52

Introduction to Spread Trading presented by Jay Richards ‘Trading with a Built-in (H)edge’ 1.

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Transcript of Introduction to Spread Trading presented by Jay Richards ‘Trading with a Built-in (H)edge’ 1.