Sunday, November 10, 2013

More on Spreads

Following previous post on spreads, we got some requests to do another post about spreads for dummies,  although there are plenty of resources in internet explaining that.

In short terms, a spread is a "stock" created by yourself (or your broker) using the difference in price of other 2 stocks (actually, they can be more than 2 and by stocks I mean shares, futures, options, etc..., but to keep it simple, lets say just 2).

To avoid confusion, just consider futures of different products or expiration date as different "stocks", so, in the former post, we take 2 products, NATURAL GAS FEB 2014 and other, NATURAL GAS MAR 2014, but we may consider any combination of 2 products, i. e.,  1 share of Apple vs 1 share of Google,  1 contract Texas oil vs 1 contract Brent oil or even using multiplicators, 1 share Google vs 20 shares Microsoft, or 1 ounce gold vs 50 ounce silver, 1 contract wheat vs 1 contract corn, etc...

In our case, it is called calendar spread because it is the same product or"underlying asset", Natural Gas, at different expiration dates, Feb and Mar 2014. As we point out, what is traded is the "difference" of price, thus, a spread is always Price A - Price B, and we earn or loose that difference. 

Warning.., applying some 5th degree maths, if you buy that spread, you buy the spread A and sell B, that is +(A - B) = +A and -B, buy A and sell B, but if you sell the spread, then -(A - B) = -A + B, that is, you sell A and buy B!!!! In our trading, we sell NG Feb 2014 and we buy NG Mar 2014.

One side effect of that is that, most brokers compensate the needed margin required in futures or option trading in case of trading same underlying asset, because you combine a long and a short position (1 buy and 1 sell). For example, to trade a single long/short position of Natural Gas my broker requires to deposit a little more than 2000$ of margin, however, to trade the spread Feb - Mar, is one fraction of that, based in the difference of the spread, in this case, around 200$ per lot (1 Feb -  1 Mar contract).  More explanation about futures contracts in Wikipedia. Of course, if spreads are based on different underlying assets, it does not apply, although some brokers may have "predefined" spreads, such as crack or crush spreads where some margin can be saved. This does not apply to cash operations with shares, ETF, etc.., just to futures, options or CFDs, and it may depend also on the Broker.

The goal of using (or "creating") a spread is to give that "new stock" some properties that make it easier to predict market's behaviour.

In the case of our Natural Gas Spread, the purpose is to obtain a clear down trend in price (in the difference), and so, try to earn some money in that difference, this is the behaviour of this difference in many years (from previous post):

Precisely, this week, the behaviour of a single Natural Gas Feb contract has been:

Which is a movement of more than 500 points (using 3 decimal numbers), from 3.820 to  3.485 and, as contract futures have a big multiplier, 0.001 = $10.00, it had more than 5000$ of volatility.., now, lets see the spread's behaviour: 

 A pick of +0.032 to a minimum of -0.006, that is, 40 basic points, 400$ per lot of movement. Clearly a more relaxed week than trading just 1 contract.

That means that, in this case, we add a clear trend, with historical data showing that behaviour to less volatility and margin requirements. I think it is worth to pay a little more commission for all these benefits. In our case, we opened the position at +0.010 and the week ended at +0.002, still some little benefit, but our expectations is it to go down to -0.020 at least. Moreover, having lower margin requirements make it easier to open several lots.

Another operation recently closed, but with an eye on that to be repeated is the spread WHEAT Jul 2014/Dec 2014, the idea would be to sell the spread when difference is around -12 or -13 and close the position around -20 or -22.

 Of course, we must always use some stops to preserve our money from mistakes, or sudden market movements that may drain all our money.., in this case, a narrow stop would be at -10, and maybe, at -5 for braver people, or people with deeper wallets...

For the initial spread with Natural Gas, my planned stop is around +0.045 where it had a double top in daily chart in July and Sept.., a little too far, I recognize, but I think it is quite unlikely to happen.

Well, maybe this post is not so much "for totally dummies", (I prefer how they say it in French, pour les nulls), but I expect is clear enough and, of course, this is not a recommendation of trading, just some information about my trading activity with some longer and boring explanations..., don't trade anything just based on this and, of course, we decline any responsibility on losses (and earnings) because of it.