ing 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 gold 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 gross 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 ARBITRAGE
 
6-month return on $36,000 cash at 7% = $1,0506-month futures price = 313.50
Less the spot price = -300.00
Gives the profit per oz. = 13.50
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 physica! 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 becalculated.
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 /imited-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,©f a 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 moreextreme. 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 theexpected supply might change a normal carry market to an inverted one, resulting in largelosses.
The Carrying Charge Spread
The carrying charge spread is a popular trade based on anticipation of interest rate changeand is, therefore, a lower risk than a net.long or short position in any market. Considergold 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 risebut who wanted to limit thé risk of a speculative position, could have entered a bull spreadby buying a deferred contract and selling a nearby contract of gold. The number of monthsbetween the contracts would determine the potential for both profit and risk; the furtherapart, 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 (e.g., March~December T-bonds) is rep-resented as variations or distortions from the normal price relationship, In this method oftrading, the distortions are also called overbought and oversold conditions and the strate-gic approach taken is countertrend. By subtracting the deferred price from the nearby(e.g., 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 will vary in a manner that allows the trader to set objectives. When March is trading1% points over December, the spread can be sold; when March trades under December by1% points, the spread can be bought.
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 b would havecaused large losses for those traders still expecting the prior market patterns; unprece-dented shifts in the spread relationship would prompt tradefs to liquidate spreads. Asperiod c begins, traders change their objectives to wait for a spread opportunity at +2,Although 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 in a range of + %. 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 to narrow. The spread between heatingoil and gasoline must be greater when those products are trading at $1.00 per gal-
 
FIGURE 13-8 Intramarket interest rate spread relationship.
March premium to December March discount to December
   
+h
Rates are expected to Rates are expected toincrease decreaseen ae NeenSource: Nancy Rothstein (Ed.), Handbook of Financial Futures, p. 359. © 1984 Nancy Rothstein, Reprinted bypermission of The McGraw-Hill Companies.324 SPREADS AND ARBITRAGE
 
FIGURE !3-9 Changing spread ranges.
 
 
fe 0 4} fe oe
 
lon than when they are at one-half that price. Figure 13-8 could easily be related to
changing price levels, where @ is a long-term bull market, peaking in period 6, and
followed by a decline to lower levels in period c.
2. Normal seasonal patterns. Seasonality causes spreads to narrow and widen in pre-dictable ways. During harvest, the basis spread (the difference between the spotand cash markets) widens, reflecting the available supply. After harvest, the basiswill continue to narrow if demand fails to materialize.
3. Specific eventsa. A freeze in coffee or orange juice results in a prolonged shift in prices, which will
then make the next year’s crop even more sensitive to a potential freeze.
b, Events that cause seasonal price changes, such as exceptional crop demand, willnullify the seasonal patterns for.the remainder of the crop year and often into thenext season. . .
c. Combination of circumstances, such as low inventory, stocks, or carryover; prioryear higher export demand; and dry, hot weather midway in the growing seasonwill result in a nervous market, causing prices to rally in anticipation of problemsbecoming real. By observing past similar situations, the extent of the rally can beobserved as large enough to use a medium to fast trend-following method, withprofit taking either at the time the trend turns or 1 month before harvest begins,whichever comes first.
Relative Spread Opportunities
The long-term analysis of a spread relationship will show the extent of variability andinclude most patterns. When the spread range is wide due to shifts caused by inventorycycles, changing public opinion, and other factors, a relative measure will be of interest.Figure 13-10a shows a simple example of a more complicated spread pattern,
The safest spread trades are those taken at historic highs and lows (H), Ls, Hg), anticipat-ing a return to normal levels; these trades do not occur often. Instead, there are many oppor-tunities to sell a relatively overbought (H, Hs, Hs, ..~) y level or buy a relatively oversold levelGi, L2,L4,...). There is less risk if the relative level is closer to the historic extreme.
The relative spread levels can be found by taking the difference between the spreadprice and a moving average. The number and magnitude of the relative tops and bottomswill vary with the speed of the trend; the faster the moving average (3 to 5 days), the morerelative highs and lows will appear and the smaller the magnitude of those moves. Figure13-10 shows a detrended spread chart based on the patterns in Figure 13-10a. The highsand lows are clear; however, it is not possible to distinguish those that have less risk fromthose with greater risk. When actually trading, selling H, is more likely to result in a lossTECHNICAL ANALYSIS OF SPREADS 325
 
————FIGURE 13-10 Relative spread opportunities. (a) Spread prices showing relative swings. (b)Prices adjusted to identify relative spread opportunities.
 
Hy Hg
Lesssellingrisk
Lessbuyingrisk
 
 
Ay Fe Hs Hy Hs He Ay
 
a ae Ly Ls de Ly(b)
 
than a profit. It will be necessary to use both charts to select the proper trades: one tolocate the relative highs and lows, the other to determine risk.
Trend Analysis of Spreads :
Moving averages, point-and-figure, and other trend-following methods are usually inap-propriate for intramarket spreads. The time needed to develop a buy or sell signal using atrending approach often takes most of the potential! profit from the trade. The magnitudeof the profits and losses resulting from these spread trades is usually small compared withan outright long- or short-market position.
Trend-following methods apply to spreads when the movement of the spread is largeenough to justify sacrificing both the beginning and end of the move to determine thedirection of the trend. Using T-bonds and T-notes as an example, the trader selects thedelivery month to be analyzed (usually the same one) and subtracts the T-note price fromthe bond price. The resulting price is treated as a single new market; a moving average,point-and-figure method, or another trend-following technique can be applied to thesenew numbers. When a buy signal occurs, the spread is bought (bonds are increasing inprice with respect to T-notes), and when a sell signal is generated, the spread is sold(bonds are decreasing in price with respect to T-notes). These techniques can work as wellasany analysis of the individual markets and lower margin requirements boost the rerurnsthat may result from net moves of lower magnitude. -
Spreads that typically allow trend analysis are those with very wide swings extendingfor long time intervals. Some examples of these spreads (Figure 13-11) are:
Short- versus long-term interest rates (trading the yield curve)Index markets representing diverse market segments
Index markets in different countries
Hogs versus cattle
Gold versus silver
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327328 SPREADS AND ARBITRAGE
 
Bull and Bear Spreads
A spread can be a low-risk substitute for an outright long- or short-trend position. In grainsand foods, a bull market will result in prices of the nearby delivery months rising fasterthan deferred months. A bull spread can be placed by entering a long position in thenearby and a short position in a deferred month. Both risk and reward are reduced; thegreater the time between months, the more volatile the spread (Figure 13-12). As in an out-right position, once the upward price peaks, the spread must be reversed because thenearby delivery will decline faster than the deferred. By selling the nearby and buying thedeferred contract, a bear spread is established.
The analysis that identifies the time to enter a bull or bear spread can be a standardtrend-following approach based on the nearby contract only. Many traders believe that thespread itself must also confirm the trend before a position is taken; therefore, a moderate-speed moving average may be applied to the spread series. This would provide a signalbased on the relative change in spread direction. A simple 1-day change might be enoughfor the fast trader. An upward trend signal in the nearby delivery and a bear spread move-ment isa conflict that should be passed.
Legging In and Out of a Spread
When both contracts, or legs, of a spread are not entered, or closed out at the samemoment, trading risk is increased. An unprotected leg of a spread is simply an outrightlong or short position and must be managed carefully. Consider a bull spread in a fast-moving market. Although both legs can be entered simultaneously using a spread order,the long position (in the trend direction) might be entered first, followed by the shortleg within a few minutes or a few days. If the market is trending steadily, profits in thelong position can be protected when the short leg is entered. Legging-in is a rewardingphilosophy when it works. When it doesn’t work, there is a large loss on the outright
 
FIGURE 13-12. Interdelivery spread volatility. (2) Actual prices. (b) Relationship ofinterdelivery spreads.
Nearby
   
Deferred
(a)
a, Spread of nearby andro’ ye farthest deferred
Spread of nearby and
first deferredZA -
()VOLATILITY AND SPREAD RATIOS 329
position, which will be difficult to offset with the lower profits from the spread. If thepurpose of trading a spread is to reduce risk, legging-in or legging-out is not going toaccomplish that goal.
Protecting an existing trend position in the nearby month by spreading with the nextdeferred delivery is not as good as simply liquidating the initial position. If the market hasbeen going up and indicates a temporary downturn, some traders will bedge by selling thefirst deferred contract. The result is a bull spread instead of an outright long. If the antici-pation of a price reversal was correct, the trade risk is reduced but there is still a loss. If thedecision was wrong, profits are reduced. Converting a potentially losing outright positioninto a potentially losing hedge changes the size of the loss or profit, It is much simpler toclose out the position rather than defer the decision.
When the trend turns from up to down, it is necessary to switch the spread from bullto bear. If large profits have been made in the bull move and both the trend and spread sig-nal a downward turn, it could be tempting to lift the long leg and hold the outright shortusing accrued profits to offset the increased risk. A more conservative trader might enter abear spread in the first and second deferred months rather than the spot and first deferred,thereby reducing risk even further and allowing smaller profits—conserving prior success.
Reverse Response to Trending Markets
Some spreads respond in just the opposite way to trends. For precious metals and pota-toes, an upward trend results in the deferred contracts rising faster than the nearby. Forexample, consider the rising price of gold, which results in a larger total contract valueand, consequently, a higher interest charge based on that value.
Traders familiar with the potato market will know that higher prices, which reflectgreater demand and product disappearance, will result in critical tightness in the last win-ter trading month. The perishable potato crop must last to early June when the first springpotatoes reach the market. Early demand on the stored crop will magnify the volatility asend of spring approaches. For both metals and potatoes, a bull spread can be entered byselling the nearby and buying the deferred contracts.
Exceptions to the Rules
During a trending period, most markets exhibit a clear relationship between delivery
months. Cattle, hogs, broilers, and eggs are nonstorable, however, and show little rela-
tionship in the response of deferred contracts to the same bullish or bearish news.During periods of exceptional demand, livestock may be marketed early causing a
strong similarity in the price patterns of cattle and hogs in the nearby contracts. Even in the
most extreme cases, this pattern cannot be carried far into the future.
VOLATILITY AND SPREAD RATIOS
Higher price levels result in increased volatility in both individual markets and their relatedspreads, Fast price movements and large swings associated with high price levels will createspread opportunities that are more profitable than normal; markets with small movementare not candidates for spreads. The combination of two low-volatility markets producesspreads with such small potential that execution costs often exceed the expected profits.
The two sides of a spread rarely have the same volatility. When badly mismatched, aspread will act the same as if you had taken an outright position in the more volatile sideof the spread. For example, Figure 13-13a shows what appears to be an excellent spreadrelationship; however, Figure 13-130 reveals that the pattern is the result of two sidewaysmarkets, one highly volatile (A) and the other with low volatility (B). Market B offers littleprotection if market A were to move sharply higher instead of sideways.330 SPREADS AND ARBITRAGE
 
RSFIGURE 13-13 Poor spread selection. (a) Spread price. (b) Spread components,
 
 
(a)
 
The same illustration would be appropriate if a gold-silver spread were created by sub-tracting the price of silver from that of gold rather than taking a ratio, Equal moves of 10%in gold from $300 to $330 and silver from $6.00 to $6.60 would result in a spread pricechange from $294.00 to $323.40, effectively mirroring the gold change rather than main-taining an unchanged spread. :
Spread Ratio
The markets which offer sound spread opportunities will vary in their absolute price rangeor volatility. For example, during 1984, the price:of spot live hog futures varied from43.80¢ to 58.00¢ per pound, whereas pork bellies ranged from 54.70¢ to 74.10¢ perpound. Both appear to be consistent in volatility as seen from the ratios, yet more than a50% difference occurred in the size of the price change.
Had the ratio been seen to drop to 1.15, a long bellies, short hogs spread would havebeen entered. If the ratio had moved to 1.35, a spread would have been entered to buyhogs and sell bellies. Assume that this distortion occurred at prices near the lows and thatprices then adjusted to 1.27 at the highs shown in Table 13-2. There are two possible tradesthat might have occurred:- -
 
 
 
Spread Contract NetPrice High PIL Size PILCase |: Long bellies 50.00 74.10 $24.10 x 38,000 $9,158Short hogs 43.48 58.00 (14.52) x 30,000 (4,356)_ Ratio 1.15 1.27 $4,802Case 2: Short bellies 54.70 74.10 (19.40) x 38,000 ($7,372)Long hogs 40.52 58.00 17.48 x 30,000 5,244Ratio 1.35 (.27 . ($2,128)ATABLE 13-2 Price Movement.of Pork Bellies and Live Hogs in 1984MeanLow High Average Range VolatilityPork bellies 54.70 74.10 64.40 19.40 30%Live hogs ~ 43.80 58.00 50.90 14.20 28% -
Ratio 1.25 1.27 1.27Spread 10.90 16.10 13.50VOLATILITY AND SPREAD RATIOS 331
 
In Case 1, the trade produces a profit while the relationship adjusts to normal; in Case2, there is a loss even though the same adjustment occurs. Two factors cause this: the dif-ferent contract sizes and the absolute price range. If the contract sizes were adjusted toequal units, which can be done by trading four bellies and five hog contracts, the resultswould be:
 
 
PIL per Number of Total
Contract Contracts PiLCase |: Long bellies $9,158 4 $36,632Short hogs (4,356) 5 21,780Spread results $14,852Case 2: Short bellies ($7,372) 4 ($29,488)Long hogs 5,244 5 26,220Spread results ($3,268)
 
This is slightly closer to the correct results but not yet right. Adjusting the number of con-tracts for volatility means attempting to equalize percentage moves per unit size. The rangeof 14.20 in hogs and 19.40 in bellies combined with their contract size gives:
 
 
ContractRange Size Total RatioBellies _ 19.40 | 38,000 $737,200Hogs 14.20 30,000 $426,000 5779: 1
 
For convenience, the ratio will be taken as 1 : 2, which means trading two hog contracts forevery one pork bellies contract. Then:
 
 
PIL per Number ofContract Contracts Net PILCase |: Long bellies $9,158 1 $9,158Short hogs (4,356) 2 (8,712)Spread results _ $446Case 2: Short bellies ($7,372) | ($7,372)Long hogs 5,244 2 10,488Spread results $3,116
 
 
Using the relative volatility and contract size to produce a spread ratio gives the correctresults.
Metal Relationships
Most metals markets showed extreme volatility in early 1980 as a result of the silver crisis.Table 13-3 gives the comparable futures price moves of the four major metals markets andshows the spread ratios that should have been used.332 SPREADS AND ARBITRAGE
 
TABLE 13-3 Metals Volatility and Spread Ratios |
 
 
Cash Prices Ratioas Contract to1978 1980 1985 Size Range Total GoldGold ($/oz) $50 850 300 100 oz 700 70,000 _-Platinum ($/oz) 170 420 300 50 oz 250 12,500 18Silver ($/oz) 5.00 38.00 6.50 5,000 oz 33.00 165,000 2.36Copper ($/ib) 60 1.35 65 25,000 Ib 75 18.750 27
 
Gold is seen to be much more volatile than either platinum or copper but less than sil-ver. During this volatile period, a spread of five platinum to one gold, four copper to onegold, and two silver to five gold would have been necessary. Unfortunately, this spreadratio represents an exceptionally volatile period. From the beginning of 1985 through June1986, the monthly average spot gold price varied from $302 to $345 per ounce—silverprices ranged from $5.11 to $6.45 per ounce. This produces the following relationship:
 
 
Contract Ratio Contracts
Range Size Total to Gold— in SpreadGold $43/oz 100 oz $4,300 3Silver $1.34/oz 5,000 oz $6,700 1.56 2
 
The ratio of three gold to two silver is normally most practical but is not safe enough whenprices move above these levels.
Volatile Spreads ~ -
Trading a high-priced spread is always riskier than one where both legs are at normal lev-els for the following reasons:
1. If only one leg is at a high level, the profitability of the spread depends entirely onthe profitable trading of the most volatile leg.
2. If both legs are volatile, specific events may cause them to move independently, cre-ating unprecedented spread levels.
3. Highly volatile spreads are usually in nearby months and may not adjust to normalbefore the expiration of the contract. At expiration, extreme demand in the cashmarket may cause further unusual spread differences. .
4. A highly volatile spread may have greater risk than a single outright position in oneleg. This is not usually the purpose of a spread’ trade.
LEVERAGE IN SPREADS
Because a spread is the difference between two or more fundamentally related markets ordelivery months of the same market, the risk is usually less than that of an outright long orshort position. Interdelivery spreads within the same crop year, or in nonagricultural prod-ucts, are recognized by the exchange as having lower risk. The result is that spread marginscan be less than 20% of the margin required for a nonspread position. Because the marginLEVERAGE IN SPREADS. 333
 
on outright positions may be as low as 5% of the contract value (underlying asset), thespread market can be as low as 2%.
The profit potential is also less for a spread than for a net long or short position. Youwould expect that, if the margin requirement is 20% of the outright position, then both therisk and reward of the trade would be about 20% of an outright position. That is not neces-sarily the case. In agricultural products, the bull and bear spreads can be highly volatile; incontrast, the potential for an intramarket metals spread is equal to the change in interestcaused by higher and lower contract values. Traders manage to compensate for the lowerprofits and risks by taking advantage of the smaller margins and