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

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. 2

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. 3

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 4

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 8

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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 ( ) 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. 11

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 12

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 13

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) 16

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. 17

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. 18

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 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. 19

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 22

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. 23

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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 and bought at -22 using a settlement gap as an initial price/profit objective. 25

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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.” 27

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” 28

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. 29

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’ 30

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” 31

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 32

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 33

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” 34

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” 35

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” 36

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” 37

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 38

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 39

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 32:1 the spread price is too narrow (historically) and that we anticipate it should widen out to say 38:1. 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. Let’s take a close look at the spread history of long gold and short silver during early May through to the end of June. 40

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, 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 $

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 37:1 - 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). 42

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 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. 43

Spread Trade Opportunities 44

Spread Trade Opportunities 45

Spread Trade Opportunities Pair #1 –ANZ/WBC 46

Spread Trade Opportunities Pair #2 – RIO/BHP 47

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 48

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Entry and Exit Strategies for Spreads Swing Line Calculation for Price Objective Recent swing high #2 is Recent swing low #1 is The difference is i.e minus = By adding this (-0.65) to we can approximate a price objective of

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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 minus -3.0= -1.2 By adding -1.2 to -3.0 we can approximate a price objective of

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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 55

SEPTEMBER/NOVEMBER Unleaded Gas 56

SEP/NOV Unleaded Gas Swing Line Calculation for Price Objective Swing high is 1129 Swing low is 932 The difference is 197 i.e minus 932= 197 By adding 197 to 1129 we create (project) a price objective of

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 58

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 $

Acknowledgements Australian Technical Analysts Association Aliom Financial Markets eSignal a division of IDC Your Trading Edge Magazine FN Arena Financial Journal Commodity Traders Almanac 60