Spread trading is a concept not all that familiar to the average commodity investor. The typical commodity trader analyzes a particular market, either from a technical or a fundamental standpoint, sometimes combining the two; makes a determination as to whether the market exhibits either a bullish or bearish bias, and then wagers by going long a futures contract or purchasing a call option, or by going short a futures contract or buying a put option. There are a number of variations on the theme, but the idea is basically the same.
The following demonstrates the inherent disadvantages in the above two basic scenarios of an outright futures position or the purchase of an option;
1. Size of account. The average investor has a limited bankroll, and can only withstand a certain amount of drawdown associated with any particular trade. The limited size of trading account necessitates the placement of a protective stop order above or below the position. The premature assumption of a position and the inherent volatility associated with commodity markets leaves the position vulnerable to a one or two day move that triggers the stop order, sidelining the trader as the position oftentimes turns back around. As the market moves in the traders favor, the advisability of using trailing stops, adjusting the protective stop in the direction of the trade makes sense in theory, but oftentimes the market will open well above or below the stop order, blowing out the stop and oftentimes taking away a substantial amount, if not all of the profit that was being locked in.
2. Time. In the case of an options purchase, you are basically purchasing time. As the purchaser of an option, the time clock and the calendar become your worst enemy. The value of your option depreciates as you wait for the market to move in your direction. Typically the purchaser of an option witnesses the market go up and down, as the value of his option changes, all along the remaining time value decaying on an accelerated curve as the option expiration day grows nearer.
Spread trading on the other hand, is a way of effectively combating the above two problems. Time no longer is an enemy and volatility, to a certain extent, is effectively neutralized. Margins are substantially reduced due to the relative conservative nature of the hedged trade, which the commodity exchanges themselves recognize. Spread trading has no directional bias. The market can go up or down, the trade is based only the relationship between the long and the short position, i.e.- as long as the long side of your spread outperforms the short side you will be profitable. Spread trades can be in the same commodity with different delivery months (i.e. buy July Lean Hogs and sell December Lean Hogs), or different commodities (i.e. buy March Swiss Franc and sell March Australian Dollar). Generally speaking, both sides of the trade will have the same overall directional bias, as in being both long and short in the Grains (long Corn/short Wheat) , or in the Meats (long Live Cattle/short Feeder Cattle), or in the Metals (long Gold/short Silver). This allows for the built in "hedge".
Seasonal spread trading is another opportunity in taking advantage of this manner of trading. As there also many seasonal tendencies associated with various commodity markets, there are also seasonal tendencies associated with seasonal spread trades. Any spread trade that has been successful say, 80% or better over the past 15 years is certainly a reasonable candidate for exhibiting a seasonal tendency and worth looking into. There are a number of advisory services that offer seasonal spread trade recommendations based on historical analysis, but to altogether ignore the technical set up may result in entering the trade too early, resulting in unnecessarily larger drawdowns, or in entering the trade too late, missing the trade altogether.
Seasonality is a seasonal cycle that forms a similar, reliable pattern every year for many years.
Reliable seasonal tendencies are all around us;
Everyone is familiar with weather seasonality. In the winter months the temperature is colder than in the summer months.
Farmers will plant crops and harvest crops at about the same time every year.
In the summer months, Crude Oil is usually higher than in winter (because people drive cars more in summer).
In the winter months heating oil is usually higher than in the summer (because more people are trying to stay warm in winter).
Any spread trade that has been successful 80% of the time or better over the past 15 years is certainly a possible candidate for exhibiting a seasonal tendency and worth analyzing further. Once the historical average optimal entry and exit dates are determined, it is time to examine the trade on the technical setup. Is the spread overbought or oversold, what are the support and resistance points? Basically does the trade look technically, as well as fundamentally sound? There are a number of advisory services that offer seasonal spread trade recommendations based on historical analysis, but ignoring the technical set up may result in entering the trade too early, resulting in unnecessarily large drawdowns, or in entering too late, missing the trade altogether. Good trading!
Robert Rutger is is a Senior Broker and principle with Transworld Futures (http://www.transworldfutures.com). He has been in the industry for going on 8 years, as a licensed Series 3 Broker, and takes the time with his clients to assist them in being successful in their commodity investment plans.