this relation-ship and cause violent distortions. ¥
‘Traders must be cautious when attempting intermarket spreads. Because they are ondifferent exchanges, the simultaneous execution of both legs cannot be guaranteed byeither exchange. In addition, each leg must be entered at the market with orders placed atalmost the same time. Further care must be taken to understand the differences in the con-tracts; for example, the three wheat contracts in Kansas City, Minneapolis, and Chicagotrade wheat of different types for different purposes, and each of the stock index marketsrepresents a different view of public participation. Intermarket wheat spreads can often gothe wrong way. Even the Dow will shift relative to the S&P 500 when market participantsconcentrate on blue chips.
Additional care is nééded when exchanges offer lower margins for intermarketspreads. A lower margin can result in extreme leverage, which may not always be justifiedfor intermarket spreads. When prices diverge, the leverage can work against you.
Product Spreads
Product spreads are very actively traded, The soybean crush, the most popular amongfutures traders, hasbeen used for many years, Product spreads usually involve three mar-
“John J. Murphy, intermarket Technical Analysis Qohn Wiley & Sons, New York, 1991)
{\|1i
 
 
 
 
ARBITRAGE - 313
FIGURE 13-2 Intermarket spread between Value Line and S&P 500.
 
 
 
Source: Commodity Research Bureau Weekly Chart Service.
kets, which may be of different delivery months, depending on the processing time. Themost common product spreads are:
Raw product(s) Resulting primary product(s) -Soybeans Meal and oif :Crude oit Gasoline and #2 heating oilFeeder cattle and grain Fat cattleFeeder pigs and corn Live hogsLive hogs Pork bellies
Exchanges often allow reduced margins when these spreads are entered in the proper pro-portion at the same time. 
314 SPREADS AND ARBITRAGE
FIGURE 13-3 A comparison of U.S. Treasury bond yields and the CRB Index, 1987-1993.A very similar trend is disrupted by an occasional large divergence. In most cases, a noticeablerise or fall in the CRB Index is followed by a change in interest rates in a manner intended tooffset the effects of inflation.
ioe ees ec met a
 
 
 
Source: Charts created with TradeStation® by Omega Research, inc.
Product spreads do not always correct for distortions within the time needed to beprofitable for the trader. When the combined return on soybean meal and oil is below thecost of crushing the soybeans, processors may execute a reverse soybean crush spread, inwhich they sell the soybeans and buy the products. Even though this appears to be a cleverway of keeping prices in-line, it is not done until the crushing margin is very negative.Processors cannot readily reduce their level of operation and lay off employees; a reversecrush means that they are buying products as well as producing them—~a position of sig-nificantly increased risk.
The Crack Spread -Crude oil is refined primarily into gasoline and heating oil. As with the soybean crush,where the processor buys soybeans and produces meal and oil, the refiner expects a profitfrom the business of buying crude oil and selling gasoline and heating oil. A speculator cantheoretically participate in this process by buying crude oil and selling the products in theright proportion and in the correct delivery months. For example, if crude oil was tradingat $20 per barrel, heating oil at 52.40¢ per gallon, and gasoline at 59.50¢ per gallon, thenbased on futures contracts of 1,000 barrels of crude and 42,000 gallons of heating oil andgasoline, we could calculate each contract value:
 
ARBITRAGE - 3s
 
Gasoline component: 59.50 x 42,000 = $24,990Heating oil component: 52.40 x 42,000 = $22,008Total components: $46,99820.00 x 1,000 = $20,000
‘Two other important facts are necessary to put this trade together:
Crude oil component:
1. It takes from 4 to 6 weeks to refine crude oil into its products; therefore, the pricesused in the crack spread should always take the product prices quoted 1 monthafter the crude price.
2. While the refining ratios can vary during the year, based on the higher demand forgasoline in the summer, and the higher demand for heating oil in the winter, thestandard ratios are found in Table 13-1.
Although there are many other by-products of the refining process, the major componentsof fuel oil and gasoline are produced in a ratio of slightly more than two parts gasoline to‘one part fuel oil on average each year. This ratio then accounts for the 3-2-1 crack spread,in which three contracts of crude oil are bought, and two contracts of gasoline and onecontract of heating oil are sold. In the example above, we can complete the net transactionas follows: '
 
 
Unit TotalMarket Price Quantity Value Units CostSell 2 Gasoline contracts 59.50 x 42,000 = $24,990 x 2 = $49,980Sell | Heating oil contract 52.40 x 42,000 = $22,008 x | = $22,008Buy 3 Crude oil contracts 20.00 x 1,000 = $20,000 x 3 = $60,000Net transaction (without costs) $11,998
‘Transaction costs will include the expectation of buying crude oil higher and selling prod-ucts lower than desired when the trade is entered, the commission, and the cost of hold-ing the contracts until delivery.
TABLE 13-{ Fuel Oil and Gas Production and Ratios, 1984-1992Fuel Oil — Gases
 
 
 
Gast ~
Resid- Gaso- Jet Kero- Fuel OitDistillate ual Total line Fuel —_ sene Total Ratio1984 981" 326 1,307 2371 414 42 2,827 2.161985 981 322 1,303 2,352 434 34 2,820 2161986 1,021 324 1,345 2,476 472 33 2,981 2221987 997 323 1,320 2,506 490 29 3,025 2291988 1,046 339 1,355 2,555 501 29 3,085 2.281989 1,152 500 1,652 2,684 544 31 3,259 1.971990 1,067 - 347 1414 2,650 556 16 3,222 2.281991 1,081 341 1,422 2,554 525 14 2,820 1981992, 1,088 326 1,414 2,591 512 1s 3418 2.20
 
‘Source:The CRB Commodity Yearbook, 1994 (John Wiley & Sons, 1994). 
 
316 SPREADS AND ARBITRAGE
 
Reverse Crack -
When the delivered price of the products totals to less than the cost of crude oil, the refinerhas no reason to process the crude oil, and can go to the market to buy the products andsell crude. This is called a reverse crack. In reality, processors can perform a reverse crackto some degree, but shutting down operations to accommodate a temporary market con-dition is not a good policy. The process of shutting down and restarting a large refinery isnot simple, and labor problems make matters more complicated. When executing areverse crack, the same delivery months are used for both crude and products.
CHANGING SPREAD RELATIONSHIPSSome spread relationships will always exist, while others may change due to:
1. Price level, such as during the silver bull market of 1980
2. Consumer tastes, such as a shift away from red meat
3. Health reasons, such as those often concerning nitrates in bacon
4. New competition, such as increased supply of edible oils from the Far East impact-ing the soybean product relationship, or the effect of high-fructose corn sweetenerson the sugar industry
Even though the market absorbs the anticipation of change in an orderly way, unexpectedevents relating to health or interruption of supply can produce a price shock that will affectmany spreads.
Gold/Silver Ratio =~
A relationship that has always been followed with keen interest is the gold/silver ratio, tra-ditionally considered normal at 33 : 1. It serves as a. good example of the variability of manyperceived spreads. When gold was $35 per ounce and silver about $1 per ounce, the rela:tionship was never very stable. Between 1930 and 1945, silver prices dropped to about$.50 per ounce; from 1951 to 1962, they remained just under $1 per ounce, and afterwardsilver began its accelerating move to $38 per ounce in January 1980. Between 1944 (whenthe International Monetary Fund (IMF) was formed) and 1971, the price of gold was fixedat $35 per ounce, although in a few years before the cancellation of the agreement, theprice varied above the designated value. From the late 1960s until the silver crisis of 1980,the gold/silver ratio ranged from about 20: 1 to 45:1 in a slow cycle. During the crisisattributed to the Hunt brothers (September 1979-September 1980), the ratio fluctuatedaround 33 : 1 ina highly volatile pattern moving only slightly above and below its historicpattern. Following the silver crisis, the value of silver declined faster than gold, reaching aratio of 56:1 in June 1982, with gold at $314 and silver at $5.57. A year later, the ratiotouched 33 : 1 and rapidly widened to 66 : 1 in June 1986.
Is the gold/silver ratio a tradable spread? Was it ever a good spread trade? Probably not.‘The relationship is mainly dependent on public perception of both items as an enduringstore of value. The same is true for the platinum/gold ratio (Figure 13-4) or the value ofgems. Prices remain strong as long as the public confidence is unshaken. There is no fun:Gamental reason for these prices to remain in the same ratio as there is for feedgrain pricesto adjust relative to their protein content.
"The public was hurt during the silver crisis. Many people made their purchases duringthe latter part of 1979, then lost heavily in 1980. At the same time that the U.S. dollar wasgaining incredible strength and interest rates were still high, gold and silver prices weredropping rapidly. -
Naturally, the value of gold did not decline as much as some other investments. Manycountries still hold gold as a store of value. But times change and there has been a notice-
 
CHANGING SPREAw aELATIONSHIPS 317
—_—_ EEEFIGURE 13-4. The platinum/gold spread, similar to gold/silver, shows periods where it mightbe successfully traded; however, markets such as 1980 always remain a possibility.
 
        
 
 
 
 
——
 
 
 
8
 
Nymex platinum vs. Comex gold‘Spot contract ——
 
Platinum/Gold
 
 
 
 
Dollars per ounce
 
 
 
 
 
cesFMAMJIJASONOJFMAMJJASOND J1980 . 1981 1982
——— << ——<———————_———————————
Source: New York Mercantile Exchange.
able shift to the U.S. dollar as an international standard. Investors feel safe with theirmoney in U.S. banks and in U.S. dollars; they are willing to suffer short-term currencyswings in exchange for security and diversification. For example, the price of oil, thelargest traded commodity in the world, is quoted in U.S. dollars rather than gold.
‘There is no doubt the U.S. dollar will lose glamour if U.S. leadership or its economyweakens; if world peace becomes a reality, the security of the dollar will also be less impor-tant. If there is significant economic instability, there may be a return to gold and diamondsas an implied standard. However, these relationships are too uncertain to be tradable,except at great risk.
Intramarket and Intermarket Financial Spreads
Spread relationships in financial markets represent anticipation of economic policy. Thespread values themselves are well defined by the interrelationship of all interest rate vehi-cles, but they will vary on the interpretation of the impact of government policy on moneysupply in reaction to the balance of trade, unemployment, and an expanding economy,and the time period in which the action will occur.
‘An intramarket spread, or delivery month spread, in a single financial instrument,such as T-bills, is a conservative speculation in changing policies as discussed in the previ-‘ous section. A bull spread, long the nearby and short the deferred, shows a belief in tem-porarily declining interest rates. An intermarket financial spread, involving differentmaturities; is a speculation in the changing yield curve. A long bonds/sbort bills positionfavors a negative carry, while long bills/short bonds expects a return-to-normal carry (withrespect to futures prices). -
Intercrop Spreads. -A special case involving carrying charges is the intercrop spread, which can be highlyvolatile, even though there is an old crop carryover that ties the two seasonal markerstogether. Soybeans, for example, are harvested mainly in September and October. TheAugust delivery is clearly the old crop, and November is the first new crop month; the Sep-tember contract often reflects the shift from old to new. 
 
 
 
318 SPREADS AND ARBITRAGE
Normally, the old crop trades at a premium to the new crop. Carrying charges, accu-mulating since the previous winter, are part of the August price; export demand may causeshortages in the old crop, which moves prices further above the cost of carry: Figure 13-5ashows the anticipated price pattern resulting from carrying charges during a normal year.The minimum storage commitment for the 3 months immediately following harvest isshown as a larger increase in price. Normal carry adds equal amounts to the price until thefollowing September, where old and new crop mix. Finally, any carryover must assume theprice of the new crop, which is in greater supply.
The theory behind an intercrop spread is that prices must come together when the oldcrop merges with the new crop. But can it be a profitable trade? Examine the two possibleevents that affect this trade:
1. Problems involving development of the new crop making supply uncertain. This
causes prices in the new crop to rise more quickly than the old crop (Figure 13-56).
2. Export demand in the old crop results in old crop prices rising faster than new cropprices (Figure 13-5¢). .
In case 1, the spread between crops narrows and can only be traded as a spread that is
short the old crop, long the new crop. This spread has limited potential since the Novem-
ber delivery cannot exceed the old crop by more than the normal carrying charge. At that
FIGURE 13-5. Intercrop spreads. (a) Normal carrying charge relationship. (b) New cropsupply problems result in narrowing spreads. (c) Export affects the old crop more thanthe new, resulting in a widening spread.
~ id crop = ~«—— New crop—>
 
 
 
 
 
CHANGING SPREAD RELATIONSHIPS 39
point, processors will buy, store, and redeliver the old crop against the new crop. Whenprices in the new crop are nearing the old crop value, it makes sense to liquidate or evento reverse the spread. Once reversed, there is little risk that the spread can move adversely.A revised crop estimate that showed better yield than originally expected would cause thenew crop to decline sharply and the spread to widen.
In case 2, export demand in the old crop causes the intercrop spread to widen at first.A spread trader will typically wait untit export commitments are complete, then sell the oldcrop and buy the new. When old crop prices rise to a large premium over the new crop,many processors will reduce purchasing based on:
1. Low or negative profit margins at the current price levels2. Use of reserves or inventory to carry processing through until the lower new cropprices are available
It is remarkable how demand is inversely related to price, even when it is consideredinelastic. When a delay in purchasing or processing will result in greater profits for thecommercial, it is somehow achieved.
Butterfly Spreads
A butterfly spread, normally referred to as just a butterfly, is a low-risk technique for cap-turing short-term interdelivery distortions. It is most appropriate in highly volatile mar-kets, where the concentration of trading in one or two delivery months causes thosecontract prices to move away from the normal delivery month relationship.
For example, in April a combination of poor planting, declines in the U.S. dollar, and
new export agreements changes the soybean prices as shown in Figure 13-6. Increaseddemand results in’sharply higher July futures prices with a tapering-off of the effect in themore deferred contracts. The normal carrying charge relationship is shown as a straightline in the old crop, beginning again in the new crop. A butterfly entered in the old cropwould mean selling two contracts of July soybeans and buying one contract each of Mayand August. This is the same as executing two spreads: long May, short July and short July,long August._ Each spread in the butterfly has a good chance of being profitable; the combination ofthe two is exceptionally good. The July contract cannot remain out-of line with the deliv-eries on both sides, because a trader could take delivery of the May contract and redeliverit in July at a profit exceeding the cost of carry. Under normal circumstances, commercialusers of soybeans will defer their purchases to later months, depleting their reserves, toavoid paying a short-term premium and causing July prices to drop.
FIGURE 13-6 Delivery month distortions in the old crop making a butterfly spread possible.
 
—————~ Cid crop New crop
Sell 2° Buy 1°
° ° ° °
May Jun Jul. = Aug. = Sep Oct-Nov Dec
  
320 SPREADS AND ARBITRAGE
‘The butterfly spread guarantees that any adjustment in the three contracts back to anormal relationship will prove profitable. If the prices of both May and August rise to be in-line with July or if May rises to form an inverted relationship, the spread will be profitable(Figure 13-7). : ;
‘The problem with such an ideal spread is the short life and difficult execution. Becauseprofits are nearly riskless, opportunity is small. The beneficiaries of these trades are usuallythe floor traders who can act quickly. Once the position is entered, liquidation can be eas-
ily accomplished.
Pseudoarbitrage of S&P Day and Night Markets
Intended to take advantage of distortions caused by S&P Market-on-Close orders andGLOBEX session, Conners and Hayward have created a GLOBEX/S&P Fair Value Program.
1. Determine the daily fair value difference between the S&P futures and cash markets,FV = SGP futures — SGP cash. Use the price as soon after the close of the NYSE aspossible, for example, 4:03 EST, leaving 12 minutes to the close of futures trading.
_ Calculate your price entry target, 7, as T= SEP cash + FV + .50, where the value .50
represents % an S&P point. /
Place a sell order at price 7: If the market is already trading above T just after the
NYSE close, then entering the order as Market-on-Close of futures is likely to be best.
4. Iffilled, cover your short if your profit is .50 during the 16 hours of GLOBEX trading.
5. Close out the trade on the close of GLOBEX if your profit has not been reached. Do
not carry the trade into the next session.
Nn
y
‘The justification for this situation is the investors’ fear of an overnight, drop in price. Itdepends on the lack of overnight news that would drive the market higher; however, ana-lysts might note that S&P price shocks always cause prices to drop. It is strongly suggestedthat no position be taken on the evening that the President gives the State of the Union
Message.
CARRYING CHARGES
‘The carrying charge structure ofa market determines the underlying differences in the rel-ative price of each contract. For metals and most storable commodities, these charges con-
5 Laurence A. Conners and Blake E. Hayward, Investment Secrets of a Hedge Fund Manager (Probus, 1995).
un  ,FIGURE 13-7 Corrections to interdelivery patterns.
 
CARRYING CHARGES 321
 
 
sist of interest, storage costs, and insurance. All else being equal, a market with normalcarry can be expected to show steadily higher prices for deferred contracts based entirelyon the cost of carry. Prices that move out-of-line may be corrected by taking delivery of thenearby and redelivering against the next contract.
It is always possible for changes in supply and demand to alter the relationship offutures contracts so that the carrying charge pattern no longer appears normal. Althoughthis is not likely to occur in the metals, it often happens that an immediate demand forfood can cause short-term increases in prices without substantial effect on more deferredmonths. This situation is called an inverted market, or negative carry, even though thecarrying charges are implicit in the price regardless of the pattern.
In the financial markets, a similar situation occurs when the demand for moneyincreases dramatically in the short term. If the market expects that the demand will beshort-lived, the rates on short-term maturities are significantly affected, whereas thelonger-term rates may show only a minor change
In the metals markets, a normal carry is called contango (a term coined by the LondonMetals Exchange when referring to copper) and a negative carry is backwardation.Changes in supply and demand that lead to backwardation are most likely to occur in theindustrial metals where the commodity is consumed at a greater rate. Gold, silver, and plat-inum, the precious metals markets, have traditionally had a uniform price relationship inthe deferred delivery months. Any deferred delivery price can be calculated by adding thecurrent rate of interest (plus storage and insurance) to the value in the cash market. Ifinterest rates rise and the price of gold remains the same, the carrying charges and thespread will increase. If the price of gold rises but interest rates remain constant, the carry-ing charges and spread will also increase because the increased value of the contractresults in higher interest costs. Similarly, lower carrying charges and a narrowing spreadwill occur if either or both the rate of interest or the price of goid declines.
The terms used in referring to carrying charges in the financial markets are the same asthose just mentioned, but the concepts are different. Carry is a term describing the yield-curve relationship. The concept of positive or normal carry is a curve that increases in yieldwith the time of maturity. The longer an investor is willing to commit money, the greaterthe yield. Negative carry can also exist for short periods of time. When economic condi-tions become unstable, the interest on short-term investments may increase sharply,although longer-term rates will increase only slightly. Investors anticipate a correction inthese short-term distortions, and do not often move money committed for longer periodsfor fear that rates will return to positive carry. The various relationships and terminologythat exist in each market sector can be found in Figure 13-1.
Implied Interest Rates
A pure carry market is one in which the forward price is entirely comprised of the costs ofholding the physical product until a predetermined delivery date. As previously men-tioned, these costs are those of storage, insurance, and the loan rate. As an example, con-sider gold, which is a classic pure carry market.
Assume that spot gold is selling for $300 per ounce and the 6-month forward contractfor $313.50, an increase of 4.5%. With interest rates at 7%, there is a possibility of increas-ing the return on investment by purchasing gold at the current spot price of $300 perounce and selling a futures contract 6 months deferred for $313.50. The grdss profit is thedifference between the futures price and the value of a comparable cash investment. Com-pare this with an initial investment of $30,000, which corresponds to the size of a 100-ounce futures contract of gold. That is,322 SPREADS AND ARBITRAGE6-month return on $36,000 cash at 7% = $1,050
6-month futures price = 313.50
Less the spot priceGives the profit per oz.Times the contract size of 100 oz. = $1,350
 
 
‘The gross improvement over the cash investment is $300, or 1% over the 6-month invest:ment period; however, there are costs involved in this cash-and-carry that do not exist in astraight time deposit. In addition to the storage and insurance of the physical gold, thereare transaction costs involved in the trading of futures. Because these costs are relativelyfixed, they are known in advance and the potential profit level of the cash-and-carry can be
calculated.
The Limited-Risk Spread
If the nearby month of a storable commodity is at a discount to a deferred month by morethan the cost of carry, a limited-risk spread may be entered by buying the nearby and sell-ing the deferred. The trader then takes delivery of the nearby and redelivers it against thelater contract. When trading commodities, which are significantly influenced by supply anddemand, the outcome of this trade is never certain.
For example, the crude oil and copper markets are not affected by weather or plantingconditions, and their supply is readily available. Demand has caused both markets tobecome inverted for long periods of time. Anticipation of lower prices, reduced demand,or 4 poor economy may result in a hand-to-mouth purchasing policy. This causes a con-centrated short-term demand in the spot market and little activity in the deferred months,resulting in higher prices in the nearby months than further out. Carrying charges are stillan integral part of the deferred price; if they were absent, the inversion would be more‘extreme. Even when they appear to have normal carry, these markets are not candidates foran implied interest rate or cash-and-carry spreads.
‘The limited-risk spread may be better termed a limited-profit spread. Whereas the car-rying charges provide a theoretical limit to the premium that a deferred month may haveover a nearby, there is no limit to the discount that a month may take on. An increase in the
. expected supply might change a normal carry market to an inverted one, resulting in large
losses.
The Carrying Charge Spread
The carrying charge spread is a popular trade based on anticipation of interest rate change
and is, therefore, a lower risk than a net long or short position in any market. Consider
gold again as an example. /
In 1978, the price of gold was low (under $200 per ounce) as were interest rates
_ (about 6%). An investor who had the foresight to expect both’ gold and interest rates to rise
but who wanted to limit the risk of a speculative position, could have entered a bull spread
by buying a deferred contract and selling a nearby contratt of gold. The number of months
between the contracts would determine the potential for both profit and risk; the further
apart, the larger the carrying charges and the greater the expected spread movement.
TECHNICAL ANALYSIS OF SPREADS
Once the spread components have been selected and there is full confidence in the under-lying fundamental relationship (even if temporary), the extreme levels and trends may befound to determine which spread trades may be entered.
 
TECHNICAL ANALYSIS OF SPREADS 323
Most technical analysis of intramarket spreads (¢.g., March-December T iresented as variations or distortions from the normat rice relationship. Inthe meahod oFtrading, the distortions are also called overbought and oversold conditions and the stratgic approach taken is countertrend. By subtracting the deferred price from the nearby(€-8., December from March of the same year) over the life of the contract for many years,the investor can measure the historic patterns (see Figure 13-8). These spread relation.ships wall vary ia manner that allows the trader to set objectives. When March is wadingints over December, the spr ;1% points over December, the sp read can be sold; when March trades under December by
Historical Comparisons
Those spreads with a sound fundamental basis will show clear patterns in their price his-tory. Analysis of longer historic periods will result in a better understanding of the consis-tency and risk involved in trading the spread. A long-term study will reveal seasonal andcyclic moves as well as periods of lower and higher volatility.
Many spread opportunities result from understanding changing spread patterns. Forexample, Figure 13-9 shows a long-term spread that has three distinct ranges, markedalong the bottom as a, b, and c. During period a, spread traders would have identified +1and 1 as the extreme levels and entered positions at those points; the risk varied butremained within an acceptable range. The higher volatility during period 6 would havecaused large losses for those traders still expecting the prior market patterns; unprece-dented shifts in the spread relationship would prompt tradeis to liquidate spreads. Asperiod c begins, traders change their objectives to wait for a spread opportunity at +2Although they could not profit from the original extreme moves because spreads wereentered too early, they are prepared for the next time. But instead of repeating itself, thespread narrows until it settles ina range of +4. If it is now traded in this range, an increaseto the prior normal levels of period a will produce a large loss. ‘
This dilemma is common to spreading; spread prices shift from one range to another,When the range decreases, few spreads are taken, and when it increases, a large lossoccurs. The following outlines possible solutions to this problem: ,
 
1. Underlying price-volatility relationship. Higher prices allow the spread to widen,whereas lower prices force the spread price t0 narrow. The spread between heatingoil and gasoline must be greater when those products are trading at $1.00 per gal-
ossFIGURE 13-8 Intramarket interest rate spread relationship.
March premium to December March discount 1 December
   
4%
 
=“%
 
Rates are expected to Rates are expected toincrease decrease
EFSFSource: Nancy Roth