Chapter 1-3 Spreads
As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called “spreads.”
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts.
Commodity spreads (or straddles) measure the price difference between two different contracts, usually futures contracts. Spreads can also measure the difference between a cash contract and a futures contract ( referred to as the basis) or the price difference between two option contracts, or various combinations of the above. For the purpose of this section you will examine spreads from the context of the price difference between two different futures contracts.(see chart below)
In the grain business the difference between two contract months of the same commodity (i.e. canola) represents the carrying charges or the cost of holding the commodity for a period of time. Carrying charges are determined by the cost of interest and storage when physical commodities are held in store. Grain traders will monitor spread relationships very closely as the relative difference between various contract positions will determine the handling margins or profitability of their involvement in marketing grain. When using spreads, the trader hopes to profit by changes in the spread (difference) between the two contracts. The trader is looking for either a widening or narrowing of the spread relationship over time. Spread trading is considered to be a less risky and often less expensive way in which to participate in the futures market. Margin requirements for spreads are generally lower than outright long or short positions, and whether the price increases or decreases the traders risk is limited to the change in the spread, since both a long and a short position are held at the same time. Since the risk is lower, so will be the potential for profit or loss. Spread trading is more complicated than outright trading and requires a higher degree of sophistication on the part of the trader. You will examine only briefly the application of spread trading to farm marketing management in this course. The purpose of this section is to familiarize yourself with the use of commodity spreads in forecasting market direction. By monitoring the relative strength between various contracts and between different markets, you will be better able to select the appropriate pricing and risk management strategies when developing your marketing plan.
Besides being used for spread trading, tracking the spread relationships between different contracts in the same market or in different markets can provide useful insights into future price direction. The relationships between the nearby and the distant months in the same commodity often tell us about the relative strength or weakness of the market itself. For example; the June 1993 Canola contract traded at a substantial premium to the November, 1993 contract up until May 1993. A perceived shortage of top quality canola following the frost of August 1992 resulted in 1992 canola values gaining on the 1993 contract positions. This relationship continued until it became apparent later in the marketing year that an adequate supply of canola was available to satisfy buyer’s needs in addition to farmers’ requirements for cash flow prior to seeding a new crop. The spread relationship between the two different marketing years then reversed direction, as buyers and sellers focused their attention on the upcoming 1993/94 canola production prospects.
In situations such as this, caused by perceived tightness of stocks, the nearby months will usually rise faster than the distant months. This is referred to as a bull spread. In order to profit from this relationship you would buy the nearby futures contract and simultaneously sell the more distant contract. Conversely in situations where the near term supplies are in relative over abundance in relation to future supplies, the nearby months will usually fall faster than the distant months. A bearish approach to the market would be undertaken by entering a bear spread.
In order to profit from this relationship you would sell the nearby contract month and buy the distant contract month. By monitoring the relationship between the nearby and the distant months, you often will be provided with a lead indication as to whether the market will trend higher or lower.
There are many different types of spreads, including:
This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates.
Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, the investor may take Short June Wheat and Long June Pork Bellies.
This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).
A credit spread is an option strategy that involves the simultaneous sale and purchase of an option with common underlays and expiration dates. As the name implies, the short options must be higher prices than the long, thus bringing a credit to the trader. For example, you may be able to sell a front month Dow 10300 call option for $650 and buy a 10500 call option for $250 to protect your short position. The trader would bring in a credit of $400 as a reward for accepting the risk of the Dow going up. Unlike selling naked options, the risk of a credit spread is limited to the spread between the strike prices minus the premium collected; in this example it would be $1,600.
Why Use Spreads?
Options provide a flexible and effective way to trade in the futures markets. They offer investors the ability to capitalize on leverage while still giving them the ability to manage risk. By combining put and call options, and investor can design a strategy that fits their expectations of market movements. Strategies will ultimately be determined by a trader’s objectives, time horizon, market sentiment, and risk tolerance. When looking for a suitable market to trade, it is often helpful to look for extreme prices. Markets coming off of long-term highs or lows present traders with an extraordinary opportunity. For example, orange juice prices are hovering near all time lows. Soon the market will be poised to rebound, giving traders one of the most advantageous times in history to be long the OJ market. This methodology is based on the idea that extreme prices are the result of extreme market conditions that cannot be sustained. However, identifying such scenarios is easy, it is more difficult to predict the timing involved. A strong trending market is also desirable. With a long-term bias in place, a trader can “ride” the market by executing several short-term trades along the way. Trending markets are excellent candidates for ratio strategies. For example, the Eurocurrency experienced a powerful uptrend beginning in 2002 and continuing into 2004. Throughout this cycle a trader could buy a call option and sell two put options below the strike of the call. The result is an inexpensive trade, with a relatively high probability of success. However, it is imperative that a trader closely monitors a trade with “naked” options. Theoretically, selling an option leaves investors with unlimited risk; but options are flexible and adjustments can be made should the market go against your position. In search of a promising option trade, it is important to look at whether or not the options are priced fairly. Option prices fluctuate according to supply and demand in the market. At times, prices become inflated or undervalued relative to theoretical models such as Black and Scholes. Buying options in times of low volatility will prove to be advantageous. A lack of deviation in the price of the underlying asset will produce cheaper options. Inversely, an option on a contract that is undergoing massive price swings will have a volatility premium built into the price. The amount of time remaining until expiration will also have an impact on option prices. Obviously, longer time horizons will be more expensive because they give the market more room to move. Similarly, in-the-money or close-to-the-money options will be highly priced because they are more likely to be profitable at
expiration. Because eight out of ten options expire worthless, it is advantageous to construct option strategies that are affordable without sacrificing the probability of profit. In other words, you want an option that is close-to-the-money but don’t want to pay a lot for it. This is easier than it sounds. Just like you would borrow money to pay for a house or a car, you can “borrow” money from the exchange to pay for trades. There are many combinations of “self-financed” trades. A ratio spread is one of them. You could by an at-the-money option and sell 2 options farther out. The money brought in through the sale of the options pays for the purchase of the third. We will go into further detail on the different types of strategies in subsequent lessons.
Profit on Probability
Obviously there is a tradeoff between capping your risk and maximizing premium collected. Armed with the notion that 80% of all options will expire worthless, many traders are tempted to sell naked options. This strategy results in a limited profit and unlimited loss. Even if an investor successfully collects premium 8 out of 10 times, the 2 inevitable losing trades will likely erase previous profits and then some. Have you ever noticed that all insurance policies have a maximum benefit? This is not a coincidence. The insurance firm Lloyd’s of London discovered the importance of limiting losses the hard way. They prided themselves on the sale of “no limit” policies, but in the early 90’s they were averaging close to $3 billion a year due to asbestos claims. Reinsurance is another way in which insurers limit their risk. After collecting premium on a policy, firms allocate a portion of the proceeds to the purchase of insurance against the sold coverage. Credit spreads can be viewed in the same terms. Following the sale of an option, it is wise to limit potential losses by purchasing protection.
Given the overall probabilities involved in option trading, one can expect to collect the premium on credit spreads nearly 80% of the time. Hypothetically, an option trader could sell 10 credit spreads with payout and risk identical to the above example and yield a $600 profit calculated as follows ($475 x 8) – ($1,600 x 2) = $600. While some commodity traders might snuff at such a meager return, in percentage terms, the reward exceeds that of most other investment options, including the stock market. If the above example requires $11,000 of margin, an investor would earn a monthly return of nearly 5.5%! “Conventional” commodity traders would be turned off at the idea of a negative risk reward ratio. Risking $1,600 to make $475 may seem to be illogical on the surface, but if you look at the probabilities involved you will find the exact opposite. Frequency of the outcomes makes it advantageous to participate in trades in which the risk outweighs the reward. This is the exact strategy that casinos have thrived off of for years. The probabilities of options trading are not so different from those in the casino industry. While there are “jackpots” to be paid, over time the expected outcome is always in favor of the house. A simple stroll down the Las Vegas Strip proves that in the long run…it pays to play the odds.