Introduction to Spread Trading presented by Jay Richards

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Introduction to Spread Tradingpresented 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

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Spread Chart of December 2010 Corn/July 2011
Corn
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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. 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

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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, 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 be right, you will
sometimes be wrong
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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 remember involve me and Ill
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
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 321 the spread price is too
narrow (historically) and that we anticipate it
should widen out to say 381. 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
- 331 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 371 - 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 371 - 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.
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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
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