Single-Stock Futures Part 16

Spreads

Spreads are strategies that involve the buying of one contract and the selling of another one. The term "spread" is used because the trader attempts to profit from a change in the spread -- the price difference between the two contracts -- as opposed to an overall rise or fall in the underlying. For example, if a January Microsoft contract is $60 and a March contract is $60.75 then the spread is 75 cents to the March side. Let's assume that you buy the January contract and sell the March. If the price of the January contract rises faster than the March contract, you will make money. This is because the amount you make on your long position is greater than the amount you lose on the short position.

To see why, assume that the January contract rises to $61 and the March contract rises to $61.50. Notice that the spread has shrunk from 75 cents to 50 cents, which is a gain of 25 cents. We can also find this 25-cent profit by considering the individual contracts rather than the spread. The January contract rose $1 (from $60 to $61) while March only rose 75 cents (from $60.75 to $61.50). Therefore, you gained $1 on the long position and lost 75 cents on the short for an overall gain of 25 cents, which is exactly the same answer we got by just looking at the difference in the spreads between the opening and closing trades. We can see these effects in the following table:

Prices do not necessarily need to rise in order for the above trader to make money either. For instance, it is possible for the January contract to fall from $60 to $59.70 while the March contract falls from $60.75 to $60.25. If so, the trader loses 30 cents on the long contract but gains 50 cents on the short contract for a net gain of 20 cents. A profit was made here because the short position fell by a larger amount than the long position. The next table shows how the same trader can make money if prices fall:

Please don't interpret this to mean that spreads will make money if prices rise or fall. We constructed both of the tables so that the trader either made more money on the long position than he lost on the short (Table 1) or that he lost less money on the long position than gained on the short (Table 2). Obviously there are other scenarios. If prices rise on both contracts as in Table 1, but the short contract rises by a larger amount, then an overall loss will occur. Similarly, if prices fall as in Table 2, we could have shown the long position falling more than the short position, which would result in an overall loss as well.

Spreads on futures contracts are a little different from spreads with options because options have strike prices and time premiums. With strike prices, there are arbitrage rules that definitively state which contract will be more valuable. For example, we know that a May $50 call will always be more valuable than a May $55 call. Similarly, we know a July $50 call will be more valuable than a May $50 call since there is more time remaining on the July option. Likewise, time premiums can determine whether the strategy is bullish or bearish. If a trader buys a May $50 call and sells a May $55 call, we know that it will result in a net debit as the time premium on the $50 call will be higher than the $55. Because this spread is paid for (net debit) we know that money must be recouped in order for it to be profitable and the strategy of buying a $50 call and selling a $55 call is therefore bullish.

However, this is not so for futures. We may think a more distant contract should be more valuable but there are no guarantees it must be so, as we learned with inverted markets. Also remember that futures contracts do not contain "time premium" above their cost of carry, so it is impossible to tell if a futures spread trader is actually bullish or bearish just by looking at the position.

If you are using spreads on futures, you need to determine the pricing relationship between the two contracts; that is, which one will move higher or lower relative to the other?

Spreads are a lower risk, lower reward strategy. In most cases, your broker will require smaller initial margin deposits if you are entering a spread order because of the reduced risk. Bear in mind that we say "in most cases." This is because your broker will want to see some type of correlation between the two assets. A high correlation simply means that the price movements are "tied together" by economic forces. Obviously buying a June Microsoft contract and selling a May Microsoft is highly correlated. If we see one Microsoft contract rise, we can be pretty sure that most of them have moved in the same direction.

Likewise, buying an airline contract and selling an oil contract is a highly correlated spread position. If oil prices rise, you can be pretty sure that airline prices will fall. Correlation does not mean that they must move in the same direction but only that we can be reasonably sure how they will move. In the case between airline stocks and oil stocks we would say the two are negatively correlated. So if you wish to enter a spread with no correlation such as purchasing a Microsoft contract and selling lean hogs, don't expect your broker to have a lower initial margin requirement!

Why Use Spreads?

While spreads are less risky, they are actually more complex for the trader to carry out profitably, which is not so for the spreads using options. The reason is that the trader must determine which contract will rise or fall relative to the other. If you think a surge in demand will occur soon, you may buy a nearby month and sell a more distant month, which is referred to as a bull spread. On the flip side, if you think there will be a fall in demand (or an increase in supply for commodities) causing the price to fall in the near term, you may sell the near-term contract and buy a more distant contract, which is a bear spread.

Key Points

The strategies of "bull spread" and "bear spread" are in relation to the near-term month. If you think the near-term month will rise relative to more distant months, you would buy the near term and sell the longer term, which is a bull spread. If you think the near term will fall faster than the longer term, you sell the near term and buy the longer term, which is a bear spread.

The Mathematical Effects of Spreads

Diversification is key to reducing the risk of any portfolio. The reason diversification helps is that the variability in any portfolio is largely caused by assets having positive correlation. In other words, when the stock market is up, most of the stocks in your portfolio will be up. When the market is down, most stocks will be down, too. Stocks tend to move in the same direction of other stocks. In order to reduce these tandem up and down swings, we need assets that pull in the opposite direction of other assets -- we need negative correlation.

Correlation is a statistical measure that shows the degree to which to variables move together. A "correlation coefficient" can be calculated and is between -1 and +1 inclusive. A correlation value of +1 means that the two assets are perfectly predictable. A move in one asset is matched by the other in exactly the same direction (because of the plus sign) and magnitude. Any stock therefore has a correlation of +1 with itself. A correlation coefficient of zero means there is no consistent way to predict the movement of one asset based on the other. In other words, the two assets move independently of each other; they are random. A correlation of -1 means the two assets are perfectly predictable, but the minus sign tells us they move in the opposite direction. If one asset is up 2%, the other is down 2%.

If you are new to investing this may be a new concept for you, so we're going to demonstrate it with an example. Say you own a small engine manufacturing factory and produce nothing but lawn mowers. If so, your sales will be up in the spring and summer months when everybody buys lawn mowers. Conversely, sales will be way down in the fall and winter months. Your business would be exposed to seasonal swings, which can hurt cash flows, profitability and growth. To guard against this, you could manufacture snowmobile engines, too. When lawn mower sales are high, snowmobile sales will be low and vice versa -- negative correlation -- and the variability of your cash flows are smoothed out.

Any time we enter a spread order or add negatively correlated positions to our portfolio, we are adding a little bit of negative correlation to the portfolio and therefore eliminating some of the fluctuations just as when snow mobile engines were added to the lawn mower factory.

We can use negative correlation easily with futures contracts. We can buy a futures contract for one particular month and sell a different month, which is called an intramarket spread. We can even buy one contract of one company and sell another contract of a different company, which is called an intermarket spread. Regardless of which type is used, the sale of the second contract creates a negative correlation for the two positions because we're selling a positively correlated asset. The risk-reducing effects can be tremendous.

For example, in the next class, we will talk about a strategy called "pairs trading," which is simply an intermarket spread. Under this strategy, the investor simultaneously buys and sells contracts of related companies such as IBM and Dell Computer. What does this accomplish? First, let's look at what happens to an investor who purchases both stocks. The effects of this purchase of two related securities can be shown mathematically with the addition of a couple more statistical measures: variance and covariance.

Variance simply describes how much variability there is between prices. The exact meaning or calculation is not important for our purposes. Let's assume that the daily variance over the past year for IBM is 0.10% and 0.12% for Dell. If Dell and IBM were independent of each other (that is, no correlation) the total variance of these two positions would be 0.10 + 0.12 = 0.22. However, because they are in the same industry, they will tend to behave similarly. We can even test this with another statistical measure called the covariance, which is similar in concept to correlation and measures how strongly the two assets move together. Again, the formula or exact interpretation of it is not necessary to understand the benefits of spreads or diversification. Let's assume the covariance between these two stocks is 0.09% per day. Once we have this information, we can determine the total variance for the two stocks combined. It will be equal to the sum of the two variances plus an additional term, which is 2 * covariance between them. The total variance is therefore 0.10 + 0.12 + (2 * 0.09) = 0.40.

Notice how the variability has risen dramatically from 0.22 to 0.40 -- nearly double -- by purchasing both stocks. This is similar to waves moving across an ocean. If waves meet in any kind of synchronized way (positively correlated), they will get bigger. Only when they are moving opposite of each other (negative correlation) will they diminish in size.Positively correlated stocks combined in a portfolio only add to the variability; they don't reduce it.

While the investor who buys both stocks may have put their money in two separate stocks, there is very little diversification benefit here since both companies are highly correlated and will tend to rise and fall together. Figuratively speaking, they have put their eggs in separate baskets but loaded those baskets onto the same truck (the computer industry). One of the biggest myths in the investment world is the belief that the idea behind diversification is to buy different stocks across the same industry. The idea is not only to have different stocks but, specifically, different stocks that are negatively correlated.

Let's see what happens with a matched pair trade and assume an investor buys IBM and sells Dell. If so, the formula is now changed and we must subtract the covariance between the two. The new variance for this investor in IBM would be 0.10 + 0.12 - (2 * 0.09) = .04%, which is less than half the amount of original variability.

The idea of creating short positions, whether for a spread or just to add to a portfolio, is one of the biggest advantages of single-stock futures for all investors. Even if you believe that shorting stocks or futures is too risky for you, it can be shown mathematically that the right contracts in the right amounts will actually reduce the variability of your portfolio -- without reducing the returns. While this may sound counterintuitive, the concept is the foundation of modern portfolio theory, which gives a broad foundation for understanding market risk and reward.

There is no easier or more cash-efficient way to reduce the overall risk of your portfolio than with futures contracts. In fact, one of the founding reasons for the creation of the broad-based futures contracts, such as the S&P 500, was so institutional traders could gain perfect negative correlation with the market by simply shorting that contract. There is no simpler way to do it. As we've said throughout the course, futures contracts were not developed for speculation even though that's the purpose for which many traders use them. Single-stock futures provide methods of hedging and speculating that are not available through any other means.

Futures Spreads

Trading market "relationships" rather than market direction.

This is a great short course in futures spreads that shows how effectively they can be used in the commodities markets. This content was supplied by our friends at Opportunities in Options (OIO), which is one of the largest and most reputable futures firms. If you have any questions about OIO, commodity or single-stock futures, please feel free to contact Greg Mitchell at 1-800-926-0926 (ext. 259) for more information.

Seasonal Futures Spreads : A Quick Introduction

1. Seasonal Spreads are simply a simultaneous buy and sell in different futures contracts. The trader is only concerned with the relationship between the prices of the different contracts involved and not with the direction each individual contract may move.

2. If a trader thinks the difference between the contracts will increase, it would be possible to win on the trade as long as the contract he buys goes up more than the one he sold, or even if the one he sold goes down more than the one he bought.

3. If a trader thinks the difference between the contracts will decrease, it would be possible to win on the trade as long as the contract he buys goes up less than the one he sold, or even if the one he sold goes down less than the one he bought.

4. These trades can involve either the same commodity with different delivery months (i.e. buy July Wheat and sell December Wheat), or different commodities (i.e. buy December Wheat and sell December Corn). We look for Seasonal Spreads that have a strong historical pattern of consistency. Although past performance does not insure future results, we sure do like to have a strong historical tendency in our favor during the time of the trade.

5. Upon entering the trade, we usually set an initial profit objective and we always have a predetermined risk level. To help establish these levels, again we find it helpful to research the history of each Seasonal Spread over the past 15 years.

Seasonal Spreads: A Detailed Explanation

The idea of "seasonal trading" in individual futures markets and futures "spreads" is based on the repetitive price patterns that many markets can exhibit throughout the year. Evaluating different known repetitive trading opportunities every month may be one of the oldest uses of a "systematic trading strategy."

For example, in physical commodity markets such as the grains, price patterns from lows to highs may be based on the normal planting and growth schedules, combined with weather cycles and demand factors. Prices may make seasonal peaks just as supplies from old crops are dwindling, before new-crop supplies are assured and hit the market. In the financial and stock markets, there are also rhythms based on institutional or government buying and selling. Annual investment patterns in the equity markets have made the six-month period from November to April far more profitable than the other six months of the year.

These "seasonal" patterns of supply and demand and the associated price patterns can be an important criteria for evaluating trading opportunities,and all traders should be "aware" of any strong seasonal tendencies normally associated with a market they are considering trading. In addition, seasonal trading and futures spreads can provide unique profit opportunities for traders willing to study this under-appreciated resource in the trading world.

One example of how a trader might use the knowledge of seasonal trading patterns in an inter-market spread can be seen in a trade in August Soybean Meal futures versus Soybean Oil in the 2000 contracts. This classic spread can often start to make a move in favor of the Soymeal starting in the spring, when the market anticipates continued strong demand for the last of the old-crop supplies of Soybean meal while recognizing a normal demand peak for Soybean Oil in May.

Historical price pattern analysis provided by Moore Research showed that entries in this spread near the end of April have a good chance of generating profits if held into the middle of July.

Well, right at the time that a trader might want to consider this spread, it was clearly in a multi-week downtrend, and most traders would want to wait for a sign that the normal seasonal pattern might actually take hold in this particular year. Spread traders know that "counter-trend" moves can be very powerful, and blindly following a seasonal trading pattern can lead to disaster.

So how might you approach a trade in this spread? Well, this is where "the art of trading" comes into play to establish a plan. In the "Winning In Futures" trading letter, the plan was to either buy the spread if it moved down to a potentially strong support area and started to recover, or broke out of its existing downtrend pattern. Here's how the trade was setting up at the time:

Excerpt from the "Winning In Futures" trading letter, April 20, 2000.

The long August Soybean Meal/ short Soybean Oil futures spread is entering a period of seasonal strength. Watch the spread for favorable price action and consider entries.

This is a classic seasonal spread, driven by the normal supply/demand dynamics between these two members of the soy complex. The market can start anticipating continued demand for the end of old-crop meal supplies, while also seeing a demand peak for soybean oil that can come in May. Technically, the spread is in a very defined downward correction channel within a longer-term uptrend.

Since the two contracts in this inter-market spread (some might say inter-commodity) trade at different point values, the spread is charted and tracked as an equity spread. This involves calculating the dollar value of each contract, and subtracting the short from the long. In this case, the last closing price for the spread was $5,542. To get that number, first calculate the value of the 100 ton soymeal contract (100 x $170.20/ton = $17,020). Then subtract the value of the 60,000 pound soyoil contract (60,000 x 19.13 cents/lb = $11,478). This gives you 17,020 minus 11,478 = 5,542.

Use either of two entry triggers for this trade:

Consider entries in this spread if it moves down further to test support in the 5400-5200 area (lateral support at the October '99 top at 5390, and a 62% retracement of the November-February rally is down at about 5228). If this support area is tested, consider an entry after the first positive close.

Also consider entries in this spread if it breaks out above the two-month downtrend line. Currently, a close at about 5800 or higher would trigger entries. The trendline is moving down at a rate of about $50 per trading day, so adjust accordingly.

The floor should accept orders based on the actual equity difference, the way the spread is charted. I have conflicting information on the margin requirements, but I believe that this spread is not given a margin break by the CBOT, so figure about $1,150 for margin per spread. Considering that it can move two or three times that amount within just a few weeks, it's still reasonable.

If entries are taken, the initial suggested risk is about $500 on a closing basis.

So, the spread was in a prime "seasonal" set-up period, and a trading plan with risk suggestions was established. It turned out that the trade entry was triggered by the market posting a bullish breakout above the downtrend line, almost right on schedule with the seasonal pattern expectation. Within just four weeks, traders had a good opportunity to take profits on this spread.

Excerpt from "Winning In Futures" trading letter, May 18, 2000.

Long August Soybean Meal/ short Soybean Oil futures spread. This trade was featured four weeks ago, and triggered entries when it broke out above the downtrend. It easily reached $2000 in profit since the breakout, and partial profits were suggested for multiple positions. It's tracked as an equity spread because the contracts trade at different point values.

The seasonal pattern can be favorable all the way into July, and another "optimal" seasonal entry point comes near the end of May. Move the trailing profit stop up to a close below $7,000 meal premium. Traders with single positions should also consider taking profits at about the $8,500 level, if reached.

Another Example of trading an "intra-market" spread is shown in the Heating Oil market. Since futures markets often "look ahead," the heating oil market often responds in the summer to anticipated demand for winter supplies. One way to play this tendency in this volatile market is buy buying a mid-winter contract (potentially the peak usage period), and selling one more deferred.

Excerpt from the "Winning In Futures" trading letter, July 13, 2000.

General Trade Comments:This week a new futures spread in the energy market is featured. We're nearing a good seasonal entry point for bull spreads in heating oil that are long a mid-winter winter contract and short one more deferred. These spreads often start working in July, as the market anticipates winter demand and starts to build inventory for the winter season. The January/March spread has already traded to very high January premiums, but the trend is up and we've seen many of the individual energy contracts and spreads challenge or exceed all-time historic extremes during the past year. As of yet, there is no convincing evidence that the bullish global supply/demand picture for energies is about to change.

It's time to start thinking about bull spreads in winter heating oil, as the industry looks to build inventory during the summer and fall.

Consider the long January/short March heating oil spread on a pullback to about 450 points January premium or lower. Limit orders are suggested in this market.The trading idea is to enter the spread near the top of the May-June consolidation, and near the rising trendline. The margin should be about $550. Suggested risk is about 100 points from entry ($420), below the bottom of the sideways consolidation from mid-May to mid-June. The high of that trading range was at 435 points January premium on May 19 and May 25, and the low in mid-June was at 375. Heating oil trades in 42,000 gallon contracts, and 100 points = 1 cent/gallon = $420. Favorable historical seasonal patterns can run into September for these spreads.

This classic seasonal spread is also featured in the July issue of the Moore Research Monthly Report. For more information and a free trial of their extensive resources on the Web, give them a call at 800-927-7259, and tell them you're one of our readers.

This spread then moved down into a strong support area and gave traders good entry opportunities in this classic "seasonal spread."

Excerpt from the "Winning In Futures" trading letter, August 31, 2000:

Long January Heating Oil/ short March futures spread. Suggested 7 weeks ago below 450 points January premium. The dip to support at the lows of the May-June consolidation provided great entries in the last half of July. The idea is that bull spreads with a long mid-winter contract in heating oil start to work as the industry builds inventory for the winter. Additional supply concerns about potential shortages have "fueled" this spread to its highest level at this time of year, and it's third-highest in at least 15 years. Normal seasonal price patterns for the spread are often favorable until the end of September, just due to the inventory building. Smaller accounts should have been taking profits near current levels, and multiple positions taken partial profits. Or, move a trailing profit stop up to 700 points January premium. From the entry area, the spread is up easily over 400 points ($1680+). In HO, 100 points = $420.

Seasonal Spreads: Questions and Answers

Which markets is this strategy used in?
We monitor numerous futures markets for seasonal strategies that fit our criteria. These markets include: grain markets (corn, wheat, soybeans, etc.), metals markets (gold, silver, copper etc.), and financial markets (stock index futures, bonds, currencies, etc.).

Does this strategy use options or futures contracts?
Futures contracts are used for many trades, but options may also be used if they can provide us with an edge.

What is the maximum risk on this strategy?
Risk levels on each trade will vary but every trade will have a pre-determined exit strategy at a specified level of loss. If left unattended, seasonal spreads could have unlimited risk.

What is the maximum profit potential of this strategy?
Seasonal spreads have unlimited profit potential but we normally suggest pre-determined profit objectives for at least part of the position.

How much of my time will it take to use this strategy?
It is up to you how closely you wish to follow each trade. Most traders who work with us stay in touch once or twice a week. (Stop) orders and profit objective orders can be taken at the same time as the entry order. This would allow you to continue trading even when you are busy or on vacation. There is no need to be glued to a quote screen all day.

How often is this strategy used?
Sometimes good opportunities seem plentiful and other times we simply wait for a nice looking trade setup. Generally speaking, with all the different market combinations, there is usually a good seasonal spread available on a regular basis.

How much trading capital does this strategy require?
Some spreads have as little as a few hundred dollars margin requirement. Others have substantially more. We recommend at least five to ten thousand dollars be made available for seasonal spread trading.

Seasonal Spreads: Summary of Benefits

1. Lower margin requirements than straight futures positions.

2. A wide variety of trading situations to choose from.

3. Not dependent on calling the correct market direction of individual contracts.

4. May be easier to predict market relationship patterns than price direction.