Online Trading Academy Article of the Week
by Don Dawson, Online Trading Academy
Commodity spread trading has been around for a very long time and is sometimes referred to as “the best kept trading secret” on the trading floors of Futures Exchanges.
An Intra-Commodity Spread is when a trader is simultaneously long and short the same Commodity, but different months. For example in this article we will be looking at Long July 2013 Lean Hogs and simultaneously Short August 2013 Lean Hogs.
An Inter-Commodity Spread would be simultaneously long and short two related Commodities. For example, Long Ten-Year Treasury Notes and simultaneously Short Thirty-Year Treasury Bonds.
Spread trading usually draws very low interest from novice traders and is mostly dominated by professional speculators and commercial traders. This is mostly because novice traders do not understand them.
Spread trading offers a way to participate in the Futures market using less trading capital than outright (net long or short) Futures contracts. Typically you will find the margin (good faith money deposited by a trader) to be about 50 – 75% less than net long or short Futures position margin. While we cannot say that trading Spreads is less risky the Exchanges that set the margin rates use volatility and risk to asses margins.
With the lower volatility in some Intra-Commodity Spreads they are good for swing trades of 10 – 60 days. By using Seasonal patterns to identify these Spreads you can have a wide choice of markets to trade. A reliable and well known source in the Futures industry for this is Moore Research (www.mrci.com). If you find you are interested in Seasonal Spreads contact MRCI ([email protected]) for an OTA free two week trial and then a 10% discount if you decide to subscribe.
But once you have a particular Spread to trade how does it look on a chart? Can you see supply/demand levels? Are there trends? As always, it is up to the individual trader to do their own technical and or fundamental analysis of the market they want to trade. Then make a decision if it meets their rules for placing a trade with their capital.
Next I would like to show you some charts of a Spread and the individual legs (longs and shorts) of the Spread. Also, we will look at a candlestick and a line on close Spread chart to see the differences.
Disclaimer: This is not a trade recommendation. I am using this as an example to show you what this Spread chart will look like.
Moore Research has a Seasonal Spread coming up for being Long the July 2013 Lean Hogs and Short the August 2013 Lean Hogs. According to their research this Spread has closed higher on July 6 than it was on June 9, 14 out of the last 15 years (93%). Can it fail this year? Of course it can! There are no guarantees in this business. Trading Seasonal patterns deals in probabilities. With a win rate like this it is has a higher chance of working than not, but without a guarantee. I have traded Spreads that were right for the last 15 years and the next year the Spread was 14 and 1.
Figure 1 is a daily chart of the July 2013 Lean Hog market.
Fig 1
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This is the buy side (leg) of our Spread Long July 2013 Lean Hogs.
Figure 2 will be a daily chart of the August 2013 Lean Hog market.
Fig 2
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This is the sell side (leg) of our Spread August 2013 Lean Hog market.
The nice thing about charting Spreads is that once you know which Spread you want to trade you do not have to chart each leg of the Spread. I showed you each of these charts so you will know where our Spread value came from. If you subtract these two contract values (July – August) you will have a Spread difference of .375 cents. To find out what our Spread price is at any given time we can get a Spread quote from the broker or our chart package.
Figure 3 will be a daily candlestick chart of historical Spread prices. Notice how this chart looks no different than a Stock, Futures or Forex chart. We can identify a trend, supply/demand levels and logical risk:reward trades. All Intra-Commodity Spreads trade in the same tick increment as their outright Futures contract does. For example, Lean Hogs are $10.00 per tick and the Spread has the same tick value.
Fig 3
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Notice the Spread value in red to the far right (.375). This is the Spread value of the two contracts we bought and sold (Long July / Short August).
Once you have created your Spread chart this will be the only chart you will use to make your supply/demand levels on. You no longer need the individual legs of the Spread charts. All analysis will be done on the Spread chart.
Figure 4 will be a Line on Close type of chart that will plot historical prices of our Spread. We can use these charts for trendline analysis, indicators and chart patterns to make buy or sell decisions. Unfortunately it will be difficult to find good supply/demand levels on this chart without candlesticks. Spread trading is done on either style of chart, it depends on your style of trading. For supply/demand traders I would recommend using candlestick charts.
Fig 4
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Spread trading can offer the Futures trader many opportunities. Some Futures traders use Spreads instead of protective stops (make sure you understand Spreads first). Spreads can be used to determine potential bull markets if the near month is at a premium to the distant month. Spreads can help tell when a major trend is about to end. These are some of the things a Spread trader can do.
Also, there are many Spreads in the Financial markets as well, not just the physical Commodity markets. There are interest rate, stock index and currency Spreads traded every day.
“You can’t get to a place that you don’t believe exists.”
Vaibhav Shah
