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Introduction to Spread Trading presented by Jay Richards. ‘Trading with a Built-in (H)edge’ www.justspreads.com.au. What is Spread Trading?. Spread Trading is when you buy a futures contract and sell a related futures contract at the same time.

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introduction to spread trading presented by jay richards

Introduction to Spread Tradingpresented by Jay Richards

‘Trading with a Built-in (H)edge’

www.justspreads.com.au

slide2

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.

slide3

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 characteristicsas an outright contract with an ‘Open’, ‘High’, ‘Low’ and ‘Settlement’ price.

3

slide4

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

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

slide8

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

slide11

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 (108.925) 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.

slide12

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
slide13

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

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slide16

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)

slide17

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.

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slide18

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.
slide19

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 2011. 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.

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slide22

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
slide23

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.”

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slide24

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”

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slide25

Discover Your Comfort Zone

  • Speculation is not the same as gambling
    • - Gambling creates risk on your money
    • - The risk in trading already exists
  • Speculators stabilize markets by creating
  • liquidity and price efficiency
  • If you rely on hope you are gambling
  • You must be able to move on from every trade (winners and losers) so you can be prepared for your next trade opportunity.

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slide26

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’

26

slide27

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”

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slide28

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

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slide29

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

29

slide30

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”

30

slide31

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”

31

slide32

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”

32

slide33

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”

33

slide34

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

34

slide35

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

35

slide36

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 $5,000
  • - 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 $2700

36

slide37

Spread Trade Opportunities

  • Two strategies for taking the Gold/Silver spread
  • Scenario #2 – Futures contracts at COMEX
  • 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 (approx) $30,000 on the Gold/ (approx) $70,000
  • profit in Silver. Approx profit is $40,000(less comm)
  • We look to sell silver the “expensive” commodity (as it relates to gold) and buy gold the “cheap” commodity (as it relates to silver).

37

slide38

Spread Trade Opportunities

  • Pair #1 –ANZ/WBC

38

slide39

Spread Trade Opportunities

  • Pair #2 – RIO/BHP

39

slide40

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 behaviourduring a specific
  • time period

40

slide43

Entry and Exit Strategies for Spreads

Swing Line Calculation for Price Objective

Recent swing high#2 is -0.75

Recent swing low#1 is -1.40

The difference is -0.65

i.e. -1.40 minus -0.75 = -0.65

By adding this (-0.65) to -1.40 we can approximate a price objective of -2.05

43

slide45

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. -1.8 minus -3.0= -1.2

By adding -1.2 to -3.0 we can

approximate a price objective of -4.2

45

slide47

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

47

slide49

SEP/NOV Unleaded Gas

Swing Line Calculation for Price Objective

Swing high is 1129

Swing low is 932

The difference is 197

i.e. 1129 minus 932= 197

By adding 197 to 1129 we create (project) a price objective of 1326

49

slide50

SEP/NOV Unleaded Gas

Review of our second example we have:

- reduced volatilityof around 90%

- reduced marginof around 90%

outright margin$5,063 spread $550

- no seasonal time frame

- bar chartshave double bottoms and

reversals to improve entry/exit levels

50

slide51

SEP/NOV Unleaded Gas

- swing lines clarify the trend

- price projectionapproximatesour

price expectation and maximizes our profit

- trade managementis greatly

improved with measured expectation

A single trade from our entry at 1020 to our exit at 1326 made around $1260

51

slide52

Acknowledgements

Just Spreads

Aliom Financial Markets

eSignal a division of IDC

Your Trading Edge

FN Arena

Commodity Traders Almanac

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