Transcript Introduction to Futures Trading Basic Concepts

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
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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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
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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)
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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, I’d spend six hours
sharpening my axe. - Abraham Lincoln
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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
Speculation is not the same as gambling
- Gambling creates risk on your money
- The risk in trading already exists
Speculators stabilize markets by creating
liquidity 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’
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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 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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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 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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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 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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Spread Trade Opportunities
Two strategies for taking the Gold/Silver spread
Scenario #2 – Futures contracts at COMEX
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 (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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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
Just Spreads
Aliom Financial Markets
eSignal a division of IDC
Your Trading Edge
FN Arena
Commodity Traders Almanac
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