ober 1980), and John F. Ehlers, “Trading Channels,”Technical Analysis of Stocks & Commodities (April 1986).
Ke 301COMBINING TECHN, | -ES
ing, point charts (the predecessor of pointand-figure charts), and waves to identify the” an . ively.irection, extent, and timing of price behavior, respective ;oe Wyekote ‘he bar chart combined price and volume to show the direction of theprice movement. In general terms, i€ shows the trading ranges in, sich supply andf .d this by giving the intensity o}demand are balanced. The volume complemente: s { trading.r hort position. Wyckoff used group charts, o:which relates to the quality of the long or sl " charts,i the stocks with the most potential, ratherindices, in the manner of Charles Dow, to select sthan looking only at individual stock price movement. This assures that the move is basedon the broader nature of the business, rather than on company politics. ‘rom tower toPoint-and.figure charts are used to condense price action. If prices move from lov! tei ime it takes to reach the new level is unimportant. Point-higher levels due to events, the time it tal h n r aaaime. As long as prices rise without a signand-figure charts record events, not time, : grificant rever5 ices change direction, a new colu Ppsal, the chart uses only one column; when prices cl : column is posted’ ¥ ¢ Chapter 9 as well as the swing trading s(see the point-and-figure section ©! > b y Sin en othai jecti d from formations in a point-and-figu:chapter). Price objectives can be determine J oie nations, TheseJated to the length of the sideways periods or bo nations.Spraeties are very different and normally closer than objectives found using similar barformations. . | |onaehe wave chart, similar to Elliott’s theories, represents the behavior of investors andthe natural chythm of the market. Wyckoff uses these waves to determine the points of bu v.ithi i! i he bar chart and point-and-i .d selling within the limitations defined by both t and po .chants. He considered it essential to use the wave charts as 2 leading indicator of pricee : imo yckott used many technical tools but not rigidly. He did not pelfeve in weinsi i il you needed—the mar -damentals but insisted, that the market action was al fmay forces of supply and demand could be found in charts: He cid nor use triangles, Toes.Sis i Rorschach test,ther formations, which he considered to be a type of : Wisnaive to the most basic patterns—the horizontal or congestion areas. He used time-+6 Jack K, Hutson, “Elements of Charting,” Technical Anabysis of Stocks & Commodities (March 1986).
FIGURE 12-9 Channel calculation.
 
       
S.N.2wR Breakout objective (VOL)
woR™ Upper band (Ui)
Dayt 
302" CHARTING SYSTEMS
 
based and event-based charts to find the direction and forecast, then relied on humanbehavior (in the form of Elliott waves) for timing. His trading was successful and his prin-ciples have survived
COMPLEX PATTERNS
Most charting systems involve a few simple rules, trying to model a price pattern that seemsto have repeatedly resulted in a profitable move. The most popular systems are simply abreakout of a previous high or low, either a horizontal pattern or a trend channel. Over theyears these approaches have proved to be steady performers. Another group of tradersmight argue that it is better to be more selective about each trade and increase the expecta-tion of a larger profit, than to take many trades to win with the long-term probabilities.
DeMark’s Sequential™
‘Tom DeMark has created a strategy, called a sequential, that finds a very overextendedprice move, one that is likely to change direction, and takes a countertrend position.”” Hisselling objective is to identify the place where the last buyer has bought. His rules use
counting and retracements rather than mathematical formulas or trendlines. To get a buy *
signal, the following steps are applied to daily data:
1. Setup. To begin, there must be a decline of at least nine or more consecutive closesthat are lower than the corresponding closes 4 days earlier (close ~ close[4} <0). Inthe case where today's close is equal or greater than the close 4 days before, thesetup must begin again. :
2. Intersection. To assure that prices are declining in an orderly fashion, rather thanplunging, the high of any day on or after the 8th day of the setup must be greater thanthe low of any day 3 or more days earlier. Note that there can be a delay before the in-tersection occurs provided that the pattern is not negated by the following rules.
3. Countdown. Once the setup and intersection have been satisfied, we count thenumber of days in which the close was lower than the close 2 days ago (close <close[2}). The days that satisfy this countdown requirement do not need to be con-tinuous. When the countdown reaches 13 we get a buy signal unless one of the fol-lowing conditions occurs: . .
a. There is a close that exceeds the highest intraday high that occurred during thesetup stage.
b. A sell setup occurs (nine consecutive closes above the corresponding closes 4days earlier).
c. Another buy setup occurs before the buy countdown is complete. In this case, therules begin again at Step 2, the intersection. This condition is called recycling.
For the sequential pattern, the sell signal is the reverse of the buy. Traders should expectthat the development of the entire formation will take no less than 21 days, but typically 24to 39 days. _
Entering the Sequential ’Once the buy signal occurs, there are thrce choices for entering the-market. The first is toenter on the close of the day on which the countdown is completed; however, this risks anew setup situation that will extend the conditions for an entry. The second requires adirectional confirmation, the close greater than the close 4 days ago, but it avoids the pos-sibility of recycling. The third is to enter a long when the close is greater than the high 2days earlier, a compromise between the first two techniques. -
© Thomas R. DeMark, The New Sctence of Technical Analysis (John Wiley & Sons, 1994).
 
 
 
COMPLEX PATTERN. - 303
—_—— eeeFIGURE 12-10 A sequential buy signal in the Deutschemark.
Deutsche Mark
 
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kt
gh
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10 28 8 22 3 19 3 an 3h 14
Ape 1989 may sue gut auteeeSource: Logical Information Machines, Inc. (LIM), Chicago, IL.
Exiting the Sequential
A number of exit conditions, consistent with the type of patterns, provide the trader withclear rules to liquidate the current trade. First, the cusrent buy setup is complete, and thelowest price recorded does not exceed the furthest price recorded by the recent inactivesetup (normally the previous sell setup). If, on the other hand, any price recorded in thecurrent buy setup exceeds the furthest price of the previous sell setup, then the position isheld until a reverse signal occurs.
‘Two stop-losses are also recommended. For a buy signal, the true range for the lowest-range day of the combined setup and countdown period is subtracted from the low of thatlowest day to create a stop-loss. Alternately, the difference between the close and the lowof the lowest day is subtracted from the low of the lowest day to form a closer stop-loss.
Considering Complex Patterns
‘There seems to be an extreme contrast between the simple robustness of a breakout sys-tem and the very complex set of circumstances that produce a signal for DeMark’s sequen-tial, The philosophic consistency of the breakout system is demonstrated by applying 
304 CHARTING SYSTEMS
 
increasingly larger breakout criteria to the same market and observing that the reliabilityand profits per trade both increase, indicating that it becomes more selective, and thosetrades that occur have a better performance profile. In the case of a single pattern, such asan island reversal or DeMark’s sequential, there is no way to measure this robustness. Forthe sequential, the time taken to identify a signal must also limit the number of signals thatare possible. Each trader must decide whether this pattern selection produces a better setof trades, or if it is too demanding to survive the test of time.
 
 
| 13
Spreads and Arbitrage
Shares is called a spread, or straddle. When the dynamics of the spread can be defin-
tively calculated, such as the price of two bonds of the same maturity and the same‘grade, or the price of gold in two different locations, the transaction can be considered anarbitrage. For futures markets, the most common use of the term spread relates to twodelivery months of the same market. For example, a trader may take a long position inMarch Treasury bonds and a short position in the June contract (for the same year). Theexpectation is that prices will rise and that near-term delivery will rise faster than thedeferred, netting a larger profit om the long position and a smaller loss on the short.
‘A spread is most often a way to reduce both the risk and, consequently, the potentialprofit that exists in an outright long or short position. A spread is commonly placed in twodelivery months of the same market, a combination of futures and physicals in the samemarket, or in two options of different strike prices or maturities. The reduction in riskdepends on the relationship between successive delivery months, which varies consider-ably with the market traded. These can be summarized as follows:
A position taken in opposing directions in related markets, contracts, options, or
Financial markets nearest to delivery react more quickly and with greater magnitudeto changing interest rates, economic data, and supply and demand situations. Thedeferred contracts will respond more slowly because the lasting effect on the market isnot as clear.
Precious metals, such as gold, platinum, and silver, were once considered pure carrymarkets, Successive delivery months would always trade at a higher price due to theinterest rate component of holding inventory. If the price of the metal rises or interestrates rise, the cost of carry increases and the spread between months widens. If metalprices or interest rates decline, the spread narrows. If metal prices and interest ratesmove in opposite ways, the effect on the spread is dampened to varying degrees. Therehas been an evolution in the industrial usc of precious metals, primarily in electronics,which has increased the consumption and changed the patterns to reflect a moreindustrial look. —_Industrial metals, such a8 copper, will show normal carrying charges under most cir-cumstances, but they are affected by demand to the extent that prices have beenknown to invert for significant periods of time. Because of their fundamental changes,silver prices inverted for the first time in 1997.
Foreign exchange rates are dependent on the prevailing economic outlook for the spe-cific country, combined with their balance of trade. A stable economy will show nearlyunchanged forward rates; a weakening economy will cause the deferred contracts tobe discounted. Prices tend to become more volatile as they move away from equilib-rium, whether higher or lower. Because exchange rates are quoted in terms of othercurrencies, everything must be viewed as relative to another economy.
Agricultural products (crops) contain a well-defined carrying charge within each cropyear. Expected variations in both supply and demand have made delivery month pat- 
306 SPREADS AND ARBITRAGE
 
terns differ from one another; however, prices rarely achieve full carry. (Note thatpotatoes are an exception to the normal patterns shown by agricultural prqducts.)
Livestock markets are noted for products that cannot be stored and redelivered; there-fore, the prices for any one contract month are based on anticipated supply anddemand at the time of delivery. Feedlots and farmers have been known to deliver earlywhen prices were high or when production costs were rising; however, this will causean unreplaceable shortage in the nearest deferred months (Figure 13-1)." Patterns in
‘Perry J. Kaufman, “Technical Analysis,” in The Handbook of Financial Futures, Nancy H. Rothstein (cd.),(McGraw-Hill, New York, 1984).
 
FIGURE 13-1 Interdelivery price relationship and terminology. (a) Precious metals. (b) Indus-trial metals. (c) Foreign exchange. (d) Agricultural products. (e) interest rates.
DeliverSpot SSS > Deterred
“Contango” (a). Precious metals‘*Price increase results in spread increase.
‘Rate increase results in spread increase.
Price—>
fanerest Fate
 
 
(b). Industeial metalsUnder normal conditions carrying chargesact as in precious metals.‘+ Extreme-dernand can cause backwardationin the near-term contracts.
{c). Foreign exchange‘sNormat market reflects prevailing3 ‘economic outlook.
‘*Economic changes could cause near-term \‘oF deferred to Move to a premium.
Price —>
 
Price—>
  
Prevailing economic outlook
 
 
(di. Agricultural products‘Normal cérry applies during 1top year under normal circumstances.stnverted markets are the result ofexiveme supply shortages
 
Price
 
fe). interest rates‘*Positive carry exists under normalconditions.‘Negative carry occurs during periodsof economic instability.
 
Yield—*
 
 
 
 
 
ARBITRAGE 307
 
delivery months are a combination of livestock on feed, expectations of marketing, andthe price of grain.
Spreads are actively traded between related products. As within a sector of the stockmarket, such as airlines or technology, there are groups of financial and agricultural marketsthat are interdependent. Globalization has made interest rates in the industrialized coun-tries respond to changes in monetary policy by the United States, Germany, and Japan.Changing interest rates then cause changes in foreign exchange rates, which also impact thelocal equities markets. The meetings of the Group of 7 (G7) further increase the chance ofa unified policy by setting common expectations among the largest economies. While thereis a clear dependence of one market on the other, the effects are highly variable.
Spreads are often unique to a specific market situation and cannot be generalized forall products. The trader must first understand the basis of the spread relationship beforeany technical analysis can be applied. It is most important that a trader understand the con-ditions under which a spread, or even an arbitrage, will fail. This chapter will present manyapproaches to spreading that very specific; examples are equally limited in scope andapplication.
SPREAD AND ARBITRAGE RELATIONSHIPS
The relationship between two markets, or between various deliveries and trading vehicleswithin the same market, will determine the type of trading strategy that may be applied.The types of spreads and arbitrage situations that are most often watched are:
1. Substitute products, such as wheat and corn or cattle and hogs. Product substitu-tion ranges from those markets that are nearly identical (e.g., 3-month T-bills and 3-month Eurodollars), to cotton and soybeans, which share the same land andgrowing season.
2. Location spreads, including gold in New York, Chicago, and London; cocoa andheating oil (gasoil) in New York and London.
3. Carrying charge spreads and cash-and-carry, where one delivery month is out-ofline with others.
4. Product relationships, such as crude oil versus heating oil and gasoline, and soy-beans versus soybean meal and oil.
5. Usage spreads, including the hog-corn ratio, feeder cattle-corn-fat cattle, cocoa-sugar, broilers-corn, and lumber-plywood.
6. Pure price differences, such as exchange and interbank currency rates, interest ratesof the same maturity and the same grade, where there is no actual cost of delivery
or carrying charges.
ARBITRAGE
‘When the two legs of a spread are highly correlated and, therefore, the opportunity forprofit from price divergence is of short duration (less than 1 or 2 days), the trade is-calledan arbitrage. True arbitrage has, theoretically, no trading risk; however, it is offset by small—profits and limited opportunity. For example, a spacial arbitrageur using the interbankmarket might call one bank in Tokyo and another in Frankfurt to find their rates on the”Mexican peso. If they differ, the trader would buy the peso from one bank and sell the peso
. at another provided:
1. The price difference was greater than the bid-asked spread, representing the cost ofconverting the currencies.2. The arbitrageur has proper credit established with both banks. 
308 SPREADS AND ARBITRAGE
 
3, The transaction can be performed simultaneously (by telephone). This requiresone trader with a telephone in each ear or two traders working side-by-side.
Large-scale arbitrage has become the domain of major financial institutions whoemploy many traders, each provided with high-tech computer displays, sophisticated ana-lytic software, and lots of telephones. These traders specialize in specific interest rate mar-Kets, foreign exchange, individual stock selection, or less often, precious metals. Theyconstantly scan quotes from across the world to find price differences, then act quicklyusing cash, forward and futures markets. They trade large quantities to profit from smallvariations. For the interest rate markets, there are computer programs that compare thevarious types of coupons and maturities to identify an opportunity quickly. Such opera-tions have become an integral part of the banking industry; they keep rates in-line withother banks and generate steady profits.
Pricing of Futures Contracts
‘The relationship of one futures market delivery month to the spot price of that market isdifferent according to the type of product, which has already been described in generalsermme, The mathematics of some of these relationships can become very complex, and thereader is referred to texts that deal specifically with these subjects.” The following sectionsdescribe the most important features of these relationships.
Storable Commodities
Storable commodities can be purchased in the cash market, stored, and sold ata later time.They can also be delivered on a futures contract, held in storage, and redelivered againstanother contract. This puts an upper limit on the amount of the carrying charges that canbe added to futures prices. The difference in cost between holding the physical commod-ity and buying it on the futures market are:
1. The financing cost involved in the purchase of the physical commodity:added interest cost = spot price ({1 + interest rate yi offutures comract — J)
Where life of futures contract is expressed in years. XN
2. The cost of storage, if any.
3. A convenience cost for not buying the physical product, and the ability to be able tosell it at any time.
These three costs are added to the futures spot price to get the fair value of the fururesprice at the time of delivery. The strategies that keep the spot and futures prices aligned,eincre Fis the futures price, is the spot price, 7 is the annualized interest rate, f is the lifeOf the futures contract (in years) from today to the time of delivery, and & is the net annualstorage cost (expressed as a percentage of the spot price) are:
Method 1: Buy the futures contract for F take delivery at expiration. Margin cost canbe collateralized. Net cost is ¥ “
Method 2: Borrow the cost of the spot commodity S and buy the physical product; paythe interest, S([1 +r] — 1), and the storage net-of-convenience cost, $x # Xf, until thecorresponding futures market delivery.
2 See Aswath Damodaran, Investment Valuation Gohn Wiley & Sons, New York, 1996, pp. 448-458), which peo-vieled the basis for these formulas, also see Marsha Stigum, Money Market Calculations (Dow Jones-irwin, 1981).
 
ARBITRAGE - 309
‘The two methods must have the same net cost; otherwise, everyone would choose thecheaper alternative. Therefore the two strategies are equal, and they form the basic arbi-trage relationship between futures and spot prices:
F=S+S((i+r} - 1) + Skt=S({1 +r] + kt)
‘This relationship represents the ideal case. If you add more realistic features, includingseparate borrowing and lending rates, r, and ra, where 7» > Tay and assume that the shortseller cannot recover the saved storage costs and must pay transaction Costs, f,, aS well, youget a normal range in which futures prices can fluctuate:
(S=-t) tr) <F<S(1 + 7p) + kt)
When futures prices move outside this range, there is a possibility of arbitrage.
Interest Rate Parity
One welkknown, second-order arbitrage combines foreign exchange forward rates withinterest rate parity. Consider the following: A U.S. corporation would like to invest $1 mil-lion for the next 6 months. The current U.S. T-bill return for the next 6 months is lower thanthe rate in West Germany, and the inflation rate is about the same. The corporation is facedwith the decision of whether to convert U.S. dollars to Deutschemarks and invest in WestGerman time deposits or accept the lower USS. rates. The decision is made easier if the cor-poration purchases goods from West Germany, since it must eventually convert US. dollarsto Deutschemarks to satisfy payments; the conversion cost ‘will then exist with either choice.
‘What if the value of the Deutschemark loses 1% against the U.S. dollar during the 6-month investment period? A corporation whose payment is stated in Deutschemarks suf-fers a 1% loss in the total interest received. If the 6-month return was 4%, interest receivedis now valued at $400 less than the $40,000 total, a small amount for the corporation mak-ing payment in Deutschemarks. A speculator would face a different problem because theentire return of $1,040,000 would be reduced by 1% to $1,029,600, netting a return ofonly 2.96%, less the additional cost of conversion. For the speculator, shifts in exchangerates often overwhelm the relative improvement in interest rate return.
"The interest rate parity theorem will normally explain the differences between the for-eign exchange rates and the relative interest rates of countries. It states that
the forward rate of a currency is equal to its present value plus the interest earnedin that country for the period of the forward rate.*
Using the futures or interbank market for the forward rate (DM; is 1 year forward)and the spot rate for the current value (DMyo,), the annual interest rate in West GermanyUce) is applied to obtain the relationship
DMy yp = DM gor (1 + Teen)Because the forward value of the U.S. dollar can be expressed similarly asUS.ty¢ = US.spoe Atlus) 7
Compute the implied interest rate/forward rate parity by dividing the second equation bythe first:
> James E. Higgens and Allan M. Loosigian, “Foreign Exchange Furures,” in Handbook of Futures Markets, PerryJ. Kaufman (ed.) ohn Wiley & Sons, New York, 1984). 
310 SPREADS AND ARBITRAGE
 
wlthU.S./DM y= U.S.ID Mapes 5 iLloer '
For example, if U.S. interest rates are 8%, West German rates are 6%, and the U.S./DM gor is0.5000, the 1-year forward rate would be1.08
.S./DM j yp = 0.5000-——U.SJDM, ,, = 0.500057
 
US./DM, = 0.5094
Crossrate Matrix Evaluation
Given the large number of currency exchange rates that can be quoted in terms of anyother currency, there are many combinations of rates that might provide an opportunityfor arbitrage. The process for uncovering those inconsistencies that offer opportunity iseasier if you put all of the rates into a table format often seen in the newspapers. Using sim-plified values, this takes the form:
— —
 
usb DEM CHE JeyusD 1.00 ’T= DEM 2.00 1.00CHF 1.25 625 1.00JPY 00! 00625 0125 1.00
Every crossrate in table T is related to every other crossrate according to:for all 4, 7, &
where the first subscript is the row, the second is the column, and each value of a repre-sents an element in the table, with ay representing currency 7 in terms of currency 7.Because the top right triangle in the table is exactly the inverse of the lower left past, it isusually omitted, Whenever a value in the empty part of the table is referenced, substitutethe inverse from the mirror image of that location: \
By X Ae = Any
ay = Vay
For the example in table Tf as; X @i2 = as2. Because there is no a4, we substitute 1/44, andBet 3,/a, = a2. Replacing this with values in the table gives 1.25/2.00 = .625, showing thatthe exchange rates between the U.S. dollar (USD), Deutschemark (DEM), and Swiss franc(CHP) are equitable. If the two sides of the equation were not the same, there would be apotential arbitrage opportunity. As in all arbitrage, the transaction costs must be subtractedfrom the opportunity to determine the realistic minimum variance for a profitable trade.
Class B Arbitrage >
7o facilitate the process of keeping prices aligned, there is Class B arbitrage, which takesadvantage of the difference between the futures and the interbank forward markets. ClassB actually refers to the category of membership on the International Monetary Market ofthe Chicago Mercantile Exchange, which provides exclusively for this type of arbitrage.Institutional Arbitrage -
Arbitrage is most often associated with institutional trading. Because profits on individualpositions are small, it is necessary to trade large numbers; hence, the capital requirements
 
ARBITRAGE : 311
can be equally large. The most well-known of all arbitrages is called program trading, theprocess by which a stock index futures market and the cash index (the weighted average ofthe actual stock prices) are kept in the proper relationship to one another.
Program Trading
‘There is nothing secret about program trading. The premise is that cash and futures priceswill come together (to within a small price difference) by the time the futures contractexpires. At that time the buyers and sellers must settle in cash at the current cash marketvalue. The price of the two markets at delivery will be:
F=SQ+r-y)
where Fis the futures price at delivery, r is the riskless interest rate, and y is the annualizeddividend yield. In addition to a deviation from this relatiqnship, you must know:
1. The transaction costs of executing both the stock and futures side of the trade. This
inchides both commissions and an estimated slippage for each of the stock issues. that must be bought.
2. The trade can only be entered with a short sale in the futures and the purchase ofstocks because of the uptick rule. The uptick rule requires that share prices only besold on an uptick, which makes it impossible to guarantee that short positions canbe entered in each stock, or that the trade can be completed in a preset time.
In addition to the large costs involved in setting a position in all of the 500 stocks thatcomprise the S&P Index, there is competition from other institutions. This limits the profitpotential of the trade to the smallest acceptable amount over the break-even level. Addingthe more realistic assumptions of distinct borrowing and lending rates made in the basicfutures arbitrage discussed earlier, plus separate transaction costs for buying stock f. andselling short ¢,, the normal futures price at delivery can vary within the band:
 (S-B)A + re ~W'< F< St E+ 7-H
Finding a Representative Subset of an Index
‘An arbitrage would be much easier and less costly if there was a smaller group of stocks orfutures markets that performed the same as the entire index. If the index is weighted bycapitalization, volatility, or some other characteristic, then sorting the components of theindex in order of largest capitalization, or highest volatility, would allow you to find a rea-sonable subset. In the case of capitalization, it is likely that a smaller group of stocks wouldrepresent 90% of the index value; therefore, that subset would perform in a way very sim-ilar to the index. Unfortunately, the S&P 500 is comprised of companies that all ‘have rela-tively high capitalization.
‘Another approach to finding a subset of markets that closely tracks the index value isby using stepwise regression, inputting all of the markets that compose the index, andExamining the weighting factors assigned to each in the answer. Those markets with thehighest weighting factors are the most significant in the movement of the overall index. Bycreating a smaller basket from those markets with the highest weighting factors, you canachieve a close approximation of the index with few components—at least temporarily.The influence of the components may change, causing the weighting factors to change;therefore, the regression would need to be rerun frequently, and the basket adjusted tostay aligned with the index. Unless you are sure that the subset of the index that represents90% of the movement will continue to reflect the index movement until expiration, youhave replaced an arbitrage with a simple speculative position.
  
312 SPREADS AND ARBITRAGE
Intermarket Spreads -The propagation of financial and stock index futures markets have expanded the numberof markets that are interdependent upon one another. Prior to the influx of financial mar-kets, product substitution (hogs and cattle, feedgrains) and location spreads were the mostcommon activity; silver in New York, London, and Chicago, and gold in New York andChicago received much attention. Now there are a large number of interest rate markets ofall maturities in many countries, and stock index markets attempting to measure high cap,low cap, and sectors, as well as the old favorites, the S&P 500 and the DJIA. Every countryseems to have introduced its equity index into the marketplace, all with the idea of com-peting for their share of hedgers, speculators, and investors.
Spreading two stock indices expresses a particular market opinion. If you considerthree popular indices, the Dow, S&P 500, and the NYSE Index, we see that each representsan increasing picture of business economy. The Dow, limited to blue chips, includes very
~Stable companies not affected by minor events. On the other end of the spectrum, the
NYSE Index is the average of all shares and expresses the broadest view of the economichealth. If you believe that the economy is headed for a downturn, but do not want to benet short the entire market, then a spread which is long the Dow and short the NYSE Indexwould be a lower-risk approach to implementing that position.
Figure 13-2 shows the spread between the Value Line Index, the first stock index mar-ket in Kansas City, and the S&P 500 in Chicago, once the most active stock spread. As isoften the case, traders are attracted to the most active market, and there is significantly lessliquidity in one leg of the spread.
There are many dependent relationships between: futures markets. Because the basisfor these are fundamentally sound, spreads are an excellent way to profit from short-termdivergence. The most comprehensive study of these relationships can be found in JohnMurphy’s Intermarket Technical Analysis,‘ in which he studies the leads and lags betweenmarkets and examines the interaction in their relationships. Of these, Figure13-3 shows how two markets can trend in the same direction, but have short periods ofextreme divergence. Interest rates, represented by U.S. bonds, are a dominant componentin the carrying charges of most markets; therefore, when yields rise, physical commodityprices rise, as seen in the CRB Index. Other events, however, can overwhelm