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Trading Spreads and Seasonals
Chapter 1What Is a “Spread?”
If you already know what a spread is, you may be tempted to skip this initialchapter. However, I advise against it. Besides being presented for those whoknow, it is presented here for those who are not sure, and also for those whoknow that they know that they don’t know.I have been amazed at the number of traders who show up at my seminarswho do not know what a spread is. Additionally, they do not know itsnumerous purposes or its many uses.A Spread is...For purposes of this book, a spread is defined as the sale of one or morefutures contracts and the purchase of one or more offsetting futurescontracts. You can turn that around and state that a spread is the purchase ofone or more futures contracts and the sale of one or more offsetting futurescontracts. A spread is also created when a trader owns (is long) the physicalvehicle and offsets by selling (going short) futures. However, this coursewill not cover the long physicals, short futures types of spreads.Furthermore, for purposes of this course, a spread is defined as the purchaseand sale of one or more offsetting futures contracts normally recognized as aspread by the futures exchanges.This explicitly excludes those exotic spreads that are put forth by somevendors but are nothing more than computer generated coincidences whichwill not be treated as spreads by the exchanges. Such exotic spreads as long
Trading Spreads and Seasonals
Bond futures and short Bean Oil futures may show up as reliable computergenerated spreads, but they are not recognized as such by the exchanges, andare in the same category with believing the annual performance of the USstock market is somehow related to the outcome of a sporting event.Either way, for tactical reasons in carrying out a particular strategy, youwant to end up with simultaneous long futures and short futures positions or,if you prefer, simultaneously short futures and long futures positions.The primary ways in which this can be accomplished are:1. Via an intermarket spread.2. Via an intramarket spread.3. Via an inter-exchange spread.Intermarket SpreadsAn intermarket spread can be accomplished by going long futures in onemarket and short futures of the same month in another market. For example:Short May Wheat and Long May Soybeans.Intermarket spreads can become calendar spreads by using long and shortfutures in different markets and in different months. These spreads arespecialized and uncommon, but it may be profitable for you know they areavailable.Intramarket SpreadsOfficially, intramarket spreads are created only as calendar spreads. You arelong and short futures in the same market but in different months. Anexample of an intramarket spread is that you are long July Corn andsimultaneously short December Corn. Other unofficial methods for creatingintramarket spreads are beyond the scope of this course.
Inter-Exchange Spreads
Trading Spreads and Seasonals
A less commonly known method of creating spreads is via the use ofcontracts in similar markets but on different exchanges. These spreads canbe calendar spreads using different months, or they can be spreads in whichthe same month is used. Although the markets are similar, because thecontracts occur on different exchanges they are able to be spread. Anexample of an inter-exchange calendar spread would be simultaneously longJuly Chicago Board of Trade (CBOT) Wheat, and short an equal amount ofMay Kansas City Board of Trade (KCBOT) Wheat. An example where thesame month is used might be long December CBOT Wheat and ShortDecember KCBOT Wheat.Offsetting ContractsAlthough both the long and the short futures may be entered simultaneouslythrough a “spread broker,” it is often advantageous to enter a spread one“leg” at a time. However, until both the long and short futures are in place,there is no offset and consequently no spread exists. Offsetting merelydefines the difference between the futures contracts, i.e., simultaneouslyboth long and short futures. A spread consists of two “legs.” Each side ofthe trade constitutes one leg. Long futures is one leg and short futures is theother leg.There are times when offsetting may be accomplished by using interexchange spreads employing differing numbers of contracts. Let’s say, forinstance, you are short 5,000 ounces of July Comex (CMX) Silver andwould like to offset with an equal amount of June Silver. You could createthe necessary inter-exchange calendar spread by purchasing five MidAmerica Exchange (Mid-Am) June, 1,000 ounce Silver contracts. Currencypositions at the Chicago Mercantile Exchange (CME) can be similarly offsetby contracts at the Mid-Am. I can offset a long CME D-Mark contract withtwo Mid-Am D-Mark contracts.Sources of Spread InformationAll the major US exchanges publish materials on seasonal spreads.Generally this material can be had free or, at most, for a nominal charge.For example, the CBOT and the CME are happy to send you lovely colorbrochures showing charts of their exchange-recognized intermarket andintramarket spreads dating back over a period of 12 years. If you call and
Trading Spreads and Seasonals
ask, they will send them at little or no charge. Don’t forget to ask for boththeir commodity and financial futures material.Years ago, before the advent of computerized data bases, I used to obtain theCBOT’s “Year Book.” I am not aware if they still publish it, but it waschock full of tables giving actual prices for every contract for an entire year.It provided me with a complete data base of prices that at the time wasincomparable. I used that data as a historical base for creating a history ofwhich spreads worked best seasonally. It was laborious and tedious work,but I manually entered much of the data into my old Epson QX-10 computerso I could produce an historical graph. The public library where I livedcarried the Year Book on its reference shelf and I made an arrangement withthe head librarian to pick up last year’s volume as soon as they received thelatest, newest volume. Seasonal tendencies in futures change little, if any,over the years. I still trade the same seasonal spreads today as I did decadesago.There are more seasonal spreads today than there were then because thereare more markets in which to trade, and because computers are able to spotvery short term trends in spreads that would have been difficult andimpractical, if not impossible, to detect by manual methods. Today, you cantrade not only agricultural spreads, but also exchange-recognized spreads inthe currency, financial, energy, and metals futures.There is also an abundance of non-seasonal, intermarket and intramarketexchange-recognized spreads. Many of these non-seasonal spreads do havesome seasonal tendencies and can be traded as seasonal spreads as well asoutright spreads based on an event, fundamental knowledge, or someobservable chart pattern.In addition to the material provided by the exchanges, there are also privatesources of information on spreads. Some of these sources, with a briefdescription of each, are listed in the Appendix B of this course.Markets Suitable for SpreadsWhen trading spreads, I am careful to trade in liquid markets and generallyreject spreads in very thin markets. However, because there is essentially nosuch thing as “stop running” when trading spreads, I can afford to take themin markets that are a bit more illiquid than what I normally would consider
Trading Spreads and Seasonals
appropriate for trading. I consider the following markets suitable for tradingspreads:Currency:British Pound, D-Mark, Swiss Franc, Japanese Yen. Any of these, oneversus the other, on an intermarket basis.Energy:Crude Oil, Heating Oil, Unleaded Gas, Natural Gas. Any of these on anintermarket or intramarket basis, along with the “Crack Spread.”Grain:Corn, Chicago Wheat, Soybeans, Chicago Oats on an intermarket orintramarket basis.Chicago Wheat and Kansas City Wheat on an intermarket or intramarketbasis.Soy Oil and Soy Meal on an intermarket or intramarket basis, and theSoybean “Crush” spread.Financial:US Treasury Bonds, Treasury Ten Year Notes, Treasury Five Year Notes,and Municipal Bonds on an intramarket basis and on an intermarket basis.(MOB spread, NOB spread, etc.)Two year notes on an intramarket basis.Eurodollars on an intramarket basis.T-Bills and Eurodollars on an intermarket basis. (TED Spread)Meat:Live Cattle and Live Hogs on an intramarket basis. Feeder Cattle on anintermarket basis with Live Cattle entered only as a spread.Metal:
Trading Spreads and Seasonals
Gold, Silver, Copper on an intramarket basis, and Gold, Silver on anintermarket basis.Softs:Cocoa, Coffee, Cotton, Orange Juice on an intramarket basis. (Caution:Coffee, Cotton, and Orange Juice in particular are among the world’s mosttreacherous markets and I never trade outright futures positions in any ofthem. In this writer’s opinion, trades in Cotton and Orange Juice should beavoided by non-commercial interests.)Of the above named markets, I will not take any trade that involves legginginto a spread in any of the following markets: Orange Juice, Heating Oil,Unleaded Gas, Copper, Coffee, Cotton, Live Hogs, T-Bills, and FeederCattle. I will leg out of any of these only in dire emergencies, preferring toliquidate the trade intact, as a spread, both legs at the same time at aspecified spread differential. “Legging in” refers to a situation in which bothsides of the spread are not put on simultaneously. “Legging out” refers toexiting the spread one side at a time and not exiting both legssimultaneously.I will not take any trades that involve Lumber, Value Line, Canadian Dollar,or Pork Bellies. I tend to reject spreads in very thin markets or deliverymonths.As a rule, I will not take any trades that involve spreads that are notrecognized by the exchange as being a spread. However, I may take a nonrecognized spread if it occurs in related markets such as Soybean Oil andSoybean Meal.Indices:S&P 500 Stock Index, Dow Jones Industrial Average Stock Index,NASDAQ 100 Stock Index, New York Stock Exchange Index
Trading Spreads and Seasonals
Chapter 2Why Use Spreads?
There are certain advantages to using spreads. Stop for a moment and thinkabout what they might be. I’ll list them here and you will also see themdiscussed as appropriate throughout the course.Advantages of SpreadsSpreads can be insensitive to the trend or lack thereof in the outright futures.Of course, there are exceptions. In a bull market, the front months usuallyoutperform the back months, and in a bear market, the back months usuallyoutperform the front months. Generally, the absolute direction of theunderlying futures is of little concern. The important thing is whether or notthe trend of the spread differential moves favorably in the direction youwould prefer.Exchange-recognized spreads carry lower initial and lower maintenancemargin requirements. This is because spreads involve lower volatility. Mostof the time true spreads do not move as frantically as do the underlyingfutures. A spread position is automatically a hedged position most of thetime and therefore usually involves less risk. Some cases of “old crop” vs.“new crop” can refute this. They sometimes look like different animals.Spreads serve to reduce the volatility impact of the underlying futures. In anintramarket spread, if the front month of a contract suddenly comes crashingdown, it is highly likely that all the remaining months will also crash down.
Trading Spreads and Seasonals
The only thing the spread trader is interested in is whether or not a change inthe spread differential has helped or hurt his position.Spreads allow a trader to take a fractional approach when putting on afutures position. Did you think you could do that only with options? Let’ssay you want to get long Treasury Bond (T-Bond) futures. After speakingwith your broker, you realize that the margin for a single T-Bond trade isgreater than you feel you can handle in your account. You notice that onmost days, Treasury Note (T-Note) futures generally move some fraction ofthe amount of T-Bond futures. You also notice that the long T-Bonds, shortT-Notes spread is widening.By going long T-Bond futures and short T-Note futures, you have created afractional position in the interest rate futures. If T-Notes are moving 80% asmuch as T-Bonds, then your spread renders a move that is 20% of a longposition in T-Bond futures. For example, if T-Bonds move up 10 points($312.50), and at the same time T-Notes move up 8 points ($250), then thespread, T-Bonds/T-notes will have widened by 2 points ($62.50) i.e., 20%($62.50 / $312.50).Spreads have yet another advantage: they are convertible. It is possible to“leg out” of a spread, leaving yourself with an outright futures position.Conversion can work both ways, outright futures may be convertible tospread positions, and spreads are convertible to outright futures positions.Convertibility adds a great amount of flexibility to your futures trading.Don’t tell them, but options traders think they’re the only ones who can dothis.Spread trading helps the trader to avoid a lot of the noise created during theintraday market trading. Much of the intraday noise is that of stop runningby the locals on the floor. There are no stops in the traditional sense withspread trades. There is no stop running available when there is no stop orderin the market. Why is there no stop running in spreads? Because the stopexists in the spread differential, and can be obtained by a combination of anynumber of futures prices. This leads to another feature of spread trading,confidentiality.When you are in a spread, and both long and short at the same time, youhave no exit order in either market. If you are long Corn and short Beans,there is no exit order in place other than to exit at a certain difference
Trading Spreads and Seasonals
between the contracts. Your trade is confidential. The locals have no ideaof your true position or intent. They can’t see both of your positions andhave no reason to look.Spreads, by their very nature, constitute a hedge. The economic rationale forthe futures markets is to provide an arena in which risk may be hedged. Afutures speculator can also hedge. His hedge is created by using anoffsetting position. He creates the offset by putting on a spread. Have youever wanted to hedge your position but didn’t know how? Spreading can, atleast temporarily, stop or lessen the pain of a bad trade.There is one further, somewhat obscure advantage of spreads. It is possiblein some markets to use far distant back months for the offsetting position. Inother instances, where you might be involved in a back month, you can usecloser-in months for the offsetting position. In a later chapter, I will showyou an example of how this advantage could have been utilized to save whatwould have otherwise resulted in a disastrous situation in the Coffee futures.Uses of SpreadsThere are numerous reasons to use spreads. You might want to pause amoment to think about what they might be. Spreads are usually, but notalways, used by speculators to reduce the risk of holding a positionovernight or, indeed, to lower risk at any time at all. Spreads are used bytraders to take advantage of historical seasonal tendencies.Spreads are used by traders to trade sideways markets where the futuresspread is trending at the same time outright futures prices are seeminglymoving sideways within Trading Ranges. Spreads are also used to convertan outright futures position to a combination futures position where thetrader feels for any number of reasons that it is better to carry the offsettingpositions available by spreading.Spreads are also used as outright intermarket and intramarket speculations.Spreads are used when there is a desire to remove the effects of futuresdirectionality or trending from a trade. Spreads can be employed to reducethe amount of initial margin and maintenance margin required to trade aparticular contract. Finally, spreads can be used to reduce and greatlyeliminate the effects of volatility and the resulting uncertainty from a trade.
Trading Spreads and Seasonals
Let’s briefly look at each of the above situations in order to gain anoverview and somewhat deeper insight into the reasoning behind each.In later chapters, when I show how I trade the various spreads, I will probethe depths of the reasons for taking spread trades. In conjunction with thereasons, I will also show you my strategies and the tactics by which I carrythem out. Keep in mind, it is entirely possible to lose on both sides of aspread.Reducing the Risk of Holding a PositionIt is not uncommon in liquid or illiquid markets for a floor trader to hedgehis position by “spreading off” against the same market in another month, oragainst a related market in the same month. I have seen this kind of floortrading tactic in such illiquid markets as the Value Line, and even in moreliquid markets such as Soybeans, Eurodollars, and Bonds. In fact,arbitraging through spreads in distant back months by financial traders iscommonly done while greatly reducing risk. If floor traders think it’simportant to “spread off,” don’t you think it’s important for you to do thesame thing?Value Line floor traders, in an effort to make a market, will take the oppositeside of an entry order coming in from off the floor. Then, because volumeand liquidity are so terribly low in this market, the Value Line floor traderwill offset his position by taking an opposite position in the S&P 500. Bydoing so, he has hedged his risk. It is not uncommon for a floor trader in theSoybean pit to offset and hedge his risk by taking an opposite equity positionin Soybean Oil or Soybean Meal.Financial floor traders will hedge risk by spreading intermarket contractsand intramarket back month contracts. Often these are not perfect spreadsand often they are not spreads recognized by the exchange as such.Nevertheless, they are regularly used by floor traders and are illustrative ofthe use of spreading off as a means to reduce risk and thereby create ahedge.Off-the-floor traders can also hedge risk by use of offsetting positions to beheld overnight. Both daytraders and position traders can create spreads thatconsiderably minimize the risk of a position that might be held overnight.Day trades can be converted to position trades by spreading. Position tradescan be held considerably longer at less risk by spreading.
Trading Spreads and Seasonals
Taking Advantage of Historical Seasonal TendenciesProbably the most common use of outright spread trading is for the purposeof taking advantage of the seasonal tendencies that occur in various futuresmarkets. Trades with a high probability of being profitable can be enteredthis way. Trades with success probabilities in the 80th and 90th percentilesare quite common among seasonal spread trades.Seasonal spreads are not exclusive to consumable commodity futures. Theyoccur in the currency and financial futures markets as well. The proof of thereliability of seasonal trading is extensive. In fact, not that many years ago itwas the mainstay of many a successful trader. Knowing when the marketsare following their normal seasonal behavior and taking advantage of thefact is one of the safest and surest ways to trade the futures markets. Onehas to be patient and restrained from greed when trading seasonals. Thereward is well worth the effort.Trading in Sideways Futures MarketsIt is not unusual for a particular futures market to be moving sideways.Experts have stated that markets spend approximately 85% of their time withtheir prices moving sideways and not trending. Whereas overall marketsmay be moving sideways, there is often a trend occurring between differentmonths of the same underlying futures or the same or various months ofrelated futures. Markets that tend to incur long periods of congestion mayvery well be trending when a front month is offset against a back month.One month may be moving sideways with an upward bias while anothermonth is moving sideways with a downward bias. The difference gives riseto a spread trend and an opportunity to profit from the spread differential.Converting an Outright Futures Position to a SpreadQuite often an outright futures position can be converted to a spreadposition. The result can be less risk and will require less margin. I haveentered such conversions in my trading and have witnessed what would havebeen a loss, had I held outright futures, turn into a profit by way ofconversion to a spread. Trades of this sort will be illustrated later in thiscourse. Ending up in a spread has usually been the result of a need orwillingness to hedge. The resulting profit has often been greater from the
Trading Spreads and Seasonals
spread than it would have been had an outright futures position beenmaintained. Have you used this privilege in your trading?Outright Inter-Exchange, Intermarket, and Intramarket SpeculationsA spread trade is often entered without the benefit of seasonality as anoutright spread position. This may be done as a counter-seasonal trade dueto backwardation in a market. Any news event, rumor, fundamental fact, ortechnical formation can cause a trader to enter a spread based on the meritsof his ascertaining that a spread trade would be in his best interests. Outrightspread trades may be entered when it is unknown which way a market willbreak from congestion. Once the break has occurred, the losing side of thespread is dropped and the winning side is maintained. Entire strategies andthe resulting tactics needed to carry them out can be built around outrightspread trades.Any time a spread is trending, sufficient reason exists to consider entry viathe spread method of trading futures. Should it become advantageous, anyspread position can at any time be converted to an outright futures trade bysimply dropping the losing side of the spread.Removing the Effects of DirectionalitySpread trades are not fully dependent upon the trend or lack thereof of theindividual futures of which they are comprised. Rather, they are dependentupon the trend of the spread differential itself. This is why, even whenmarkets are not trending, a spread trade can make money from the trend inthe spread differential. However, spreads can also make profits in trendingmarkets. If the long side of a spread trade trends higher and faster than theshort side of that same trade, profits will be acquired by virtue of the upwardtrend in the spread differential.In like manner, if the short side of a spread trends lower and faster than thelong side of that same trade, profits will be acquired by virtue of the upwardtrend in the spread differential. This may seem confusing, but it points outthe fact that the trend of a spread can be up even while the two legs of thespread contract are plunging down.Both Sides of a Spread Can Win or Lose
Trading Spreads and Seasonals
While on the subject of directionality, keep in mind that directionality ofprofit or loss is another matter. It is entirely possible to be profitable on bothsides of a spread as well as to be unprofitable and actually lose on both sidesof a spread.Reducing the Amount of Initial and Maintenance MarginExchanges recognize the reduced risk of spread trades and the correspondingreduction in the effects of volatility by making the margin requirementsnecessary to carry spread trades much lower than those for outright futurestrades. Spreads are generally fractionally less volatile than outright futurespositions.Every spread trade carries in it the elements of hedging, and the elements ofrisk. Hedgers require less margin to trade because they are both long andshort the same or a related commodity. That is one reason why, with a fewexceptions involving related markets, we do not advocate exotic, exchangenon-recognized spreads for purposes of this course. Lowered marginrequirements are a major positive reason for entering spread trades. Lowermargins can mean more opportunities to enter or add to positions in the samemarket or to diversify through additional positions in other markets. If youare trading a small account, are you aware that spread trading may offer away to obtain more trading opportunities?Reduce and Greatly Eliminate the Effects of Volatility and UncertaintyAs stated above, it is the hedging nature of spreads that can reduce risk andmargin. This reduction is directly related to the lessened exposure tovolatility that may be carried by spread trades. If you are both long andshort the Japanese Yen and it explodes into a 500 point price rise in a singleday, you may profit if the long side of the trade moves up more than theshort side. If the opposite is true, you will lose only fractionally the amountyou would have lost if you were holding an outright short futures position.The long futures will always mitigate the effects of any loss you might betaking on the short side of the spread trade.Disadvantages of SpreadsSince I’ve been listing the advantages of spreads, it is only fair that I list thedisadvantages of spreads. Nothing in life is perfect. Spread trading is nottotally without some drawbacks. You wouldn’t want me to pretend there arenone, would you?
Trading Spreads and Seasonals
Probably the greatest disadvantage in the minds of some traders is thattrading spreads limits profit potential. Of course, this is true. When youlimit the risk in a trade, you usually end up limiting the amount of profitavailable in that trade. Limited profit potential must be weighed against thebenefits and advantages that accrue to a trader who utilizes spreads.Another disadvantage in spread trading is the limited amount of writteninformation about spreads. There are few books indeed that cover thesubject. One of the reasons for my preparing this course is to provide an indepth treatment of the subject of spread trading.Ordering of spread trades is another draw-back for many traders. It takes agreater effort to place a spread order than other types of orders. Althoughthe ordering of a spread trade involves no more than a few additional words,this seems to be an insurmountable obstacle for those not willing to make theeffort. I believe this degree of reluctance derives from the fact that tradersare not sure of themselves when it comes to placing spread trades. This lackof certainty revolves around not understanding the mechanics of ordering,and also a lack of understanding of how spread trades work.Ignorance in this area is not solely in the realm of the trader. It also involvesthe broker. This leads to another disadvantage of spread trading, brokeruncertainty.I’ve been amazed at how few brokers know anything about how to place aspread order. Therefore they are sometimes of little help to the traderseeking such information. That’s too bad, isn’t it?Perhaps the final disadvantage of spread trading is found at the spread deskitself. For spreads that involve the existence of an actual spread desk, i.e.,spreads like the TED spread which involves a spread across two markets,and therefore trades at an official TED spread desk of the InternationalMoney Market, there is a loss of the confidentiality that is available were thetrader to avoid the spread desk and simply leg into the spread trade.I feel that it is often better to leg into spreads, especially where the trader hasthe time and resources to observe the market and enter at a more propitiousdifferential. The back office computer is oblivious to legging in. It cannottell whether the spread was entered as a spread or was entered by legging-in.
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