stein (Ed.), Handbook of Financial Futures, p.359.© 1984 N: i
eh ), 7 lancy Rothpermission of The McGraw-Hill Companies. , 7 Rowsein. Reprinced by 
 
 
 
 
324 SPREADS AND ARBITRAGE
FIGURE 13-9 Changing spread ranges.
pe a tee
nce
lon than when they are at one-half that price. Figure 13-8 could easily be related tochanging price levels, where a is a long-term bull market, peaking in period b, andfollowed by a decline to lower levels in period ¢.
>. Normal seasonal patterns. Seasonality causes spreads to narrow and widen in Pre-dictable ways. During harvest, the basis spread (the difference between the spotcae ash 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 resulthen 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 the
next season.c. Combination of circus
ts in a prolonged shift in prices, which will
mstances, 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 inventory
cycles, 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 (HZ, H,), anticipat-these trades do not occur often. Instead, there are many oppor
ing a return to normal levels;tunities to sell a relatively overbought (Hz, Hs, Ha - - “level or buy a relatively oversold level(Ly, La, Lays +) ‘There is less risk if the relative Jevel 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. Figure13-10b shows a detrended spread chart based on the patterns in Figure 13-10a. The highsdnd lows are clear; however, it is not possible to distinguish those that have less risk from
those with greater risk. When actually trading, selling H, is more likely to result in a loss
Boe:
TECHNICAL ANALYSIS OF SPREADS325
=FIGURE 13-10 Relative s iti
! pread opportunities. (a) Spread pri i iPrices adjusted to identify relative spread opparunitien, prices showing relative swings. (2)
 
 
Ay HeLesssellingriskLessbuyingriskHy Fe Hy Hy Hs gy
 
 
Tyg dg kg gg)
 
than a profit. It will be necessary to use both charts to select the proper trades: one tothe propeilocate the relative highs and lows, the other to determine risk.
Trend Analysis of Spreads
Movi ,Hropriate for tna point-and-figure, and other trend-following methods are usually inapropriate ntramarker spreads. The time needed to develop a buy or sell signal using atrending approach often takes most ofthe potential profit from the trad, The magnitudeing from these spread i ian outright long- or short market position Bread erades is usually small compared withenone 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 wend Using T-bonds and T-notes as an example, the trader selects thdelivery month to be analyzed (usually the same one) and subtracts the Pnote price fromthe bond price. The resulting price js teated a a single new market, a moving averpolntand-igare method, or another trend-following technique can be applied to thesenew numbers. pen a buy signal occurs, the spread is bought (bonds are increasing inprice with respect to Tnotes), and when a sell signal is generated, the spread is sold(bonds are decreasing in rice with respect o T-notes), These techniques can works wellarkets ane i ithat may result from net moves of lower mmagainade Be turements Pose she reraenspreads that typically allow trend analysi: h i ersds th lysis are those with very wide swi ifor long time intervals, Some examples of these spreads (Figure B11) er eeShort- versus long-term interest rates (trading the yield curve)Index markets representing diverse market segmentsIndex markets in different countriesHogs versus cattle :Gold versus silver :Currency crossrates“ve oF fz et ez GF
90 | a8FoF y of @
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326
  
SPREADS AND ARBITRAGE328
Bull and Bear Spreads sion tara
A spread can be a low-risk substitute for an outright long- or short-trend position. Tn grains
and foods, a bull market will result in prices of the nearby delivery months rising faster
than deferred months. A bull spread can be placed by entering 2 long position in the
ition i h. Both risk and reward are reduced; the
nearby and a short position in a deferred month ; fe reduced: the
i hs, the more volatile the spread (Figure 13-12).Fee a ae eee upward pri d must be reversed because theight position, once the upward price peaks, the spread mi 2neuer lelivery will decline faster than the deferred. By selling the nearby and buying theferred contract, a bear spread is established.
“ <The analysis that identifies the time to enter a bull or bear spread can be a ssandard
trend-following approach based on the nearby contract only. Many traders believe tha the
d before a position is taken; therefore, -
spread itself must also confirm the tren ns take refore, a moderatei ied to the spread series. This would prot gn:
speed moving average may be applied to d series. This would provide 4 sinal
based on the relative change in spread direction. A simple 1-day :
for the fast wader. An upward trend signal in the nearby delivery and a bear spread move
ment is a conflict that should be passed.
 
Legging In and Out of a SpreadRen s, of a spread are not entered, or closed out at the same
both contracts, or leg: sed aween trading risk is increased. An unprotected leg of a spread is simply an outright
iti ider a bull spread in a fast-Short position and must be managed carefully. Consi 2
eee sae key. Although both legs can be entered simultaneously using a spread ordes,
ition (i i i .d first, followed by the sde osition (in the trend direction) might be enteres rst, w ;
tee within a few vainutes ora few days. If the market is trending steadily, profits in thetong position can be protected when the short leg is entered. Legging-in is a rewardsphilosophy when it works. When it doesn’t work, there is a large loss on the outright
 
FIGURE 13-12. Interdelivery spread volatinterdelivery spreads.
 
 
‘. ‘Spread of nearby andve Me farthest deferredWwa Spread of nearby andoe a first deterredalt -ae .
 
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 cotal 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 fast 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 deliverymonths. 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 astrong similarity in the price patterns of cattle and hogs in the nearby contracts. Even in themost 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 13-136 reveals that the pattern is the result of two sidewaysmarkets, one highly volatile (A) and the other with low volatility (B). Marker 8 offers litdeprotection if market A were to move sharply higher instead of sideways. 
 
330 SPREADS AND ARBITRAGE
FIGURE 13-13 Poor spread selection. (a) Spread price. (6) Spread components.
 
 
 
 
 
 
(a (b)i
‘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:. -
ee
 
Spread Contract Net
Price High Pit Size PIL
Case I: Long bellies 50.00 74.10 $24.10 x 38,000 $9,158Short hogs 43.48 58.00 (i452) x 30,000 (4,356)
Ratio 145 127 $4,802
Case 2: Short bellies 54.70 74.10 (19.40) x 38,000 ($7,372)Long hogs 40.52 58.00 1748 x 30,000 5,244
” Ratio 1.35 1.27 ($2,128)
TABLE 13-2 Price Movement.of Pork Bellies and Live Hogs in 1984
 
 
MeanLow High Average Range Volatility
Pork bellies 54.70 74.10 64.40 {9.40 30%
Live hogs ~ 43.80 58.00 50.90 14.20 28% —
Ratio 1.25 "127 1.27
Spread 10.90 16.10 13.50
Spread 10-901
 
VOLATILITY AND SPREAD RATIOS 331
9 incase bs 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 different contract sizes and the absolute price range. If the contract sizes were adjusted to
ahaa ‘ P 7equal units, which can be done by trading four bellies and five hog contracts, the results
 
 
PIL per Number of TotalContract Contracts PIL
Case |: Long bellies $9,158 4 $36,632Short hogs (4,356) 5 21,780Spread results $14,852
‘Case 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:
 
 
Contract
Range Size Total RatioBellies _ 19.40 38,000 $737,200Hogs 1420 30,000 $426,000 S779:1
 
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) 1 ($7,372)Long hogs 5,244 2 10,488Spread results $3,116
 
Usiog 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.asa
332 SPREADS AND ARBITRAGE
TABLE 13-3 Metals Volatility and Spread Ratios i
 
 
 
Cash Prices RatioContract to1978 1980 1985 Size Range Total GoldGold ($/oz) 150 850 300 100 oz 700 70,000 _Platinum ($/oz) 170 420 300 50 oz 250 12,500 ASSilver ($/oz) 5.00 38.00 6.50 5,000 oz 33.00 165,000 236Copper ($/lb) 60 135 65 25,000 Ib 75 18.750 27
Copper (6/6)
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:
a
 
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
Siver 813402 EE
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 Gt normal lev-els for the following reasons:
1. If only one leg is at 2 high level, the profitability of the spread depends entirely onthe profitable trading of the most volatile leg.
2. Ifboth 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, Ahighly volatile spread may have greater risk than a single outright position in oneleg. This is not usuaily 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 or”shost position. Interdelivery spreads within the same crop year, or in nonagricultural prod-hiets, 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 margin
 
LEVERAGE IN SPREADS333
on outright position out ight positions may be as low a8 5% of the contract value (underlying asset), the
The profit potential is also less for a spread than for a net long or short position. Youwould expect that, ifthe 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 entering more positions.With five contracts, the trader has managed to convert a conservative spread trade into thesame risk and reward as a nonspread trade—pethaps with even higher risk—without addedcapital. The small trader, however, should not leverage spreads to their maximum,
Some trades that derive the benefit of spread margins are not always of proportion.ately less risk, For example, when the IMM began, any two currencies could be spread withreduced margin. A short position in the Deutschemark against a long position in the Mex-ican peso would hardly have been considered reduced risk when the first devaluation ofthe peso occurred. The trader must keep in mind that the decrease in margin, whichaccompanies spreads entered on the same exchange, will cause a substantial increase inatte rice may counteract the intrinsic risk reduction in a spread that was related to the
movement. reads are not il i ‘adilsmaller pice movement. Spread ae no necessarily less speculative or safer than trading 
 
 
7 14
Behavioral Techniques
 
‘and cannot be represented by pure mathematics. When viewed in the short term,most systems will be more representative of behavior than economic factors because,over a few hours of one day, the long-term influence of the trend is very small. The con-cepts presented in this chapter deal specifically with human reactions. Measuring the newscovers an area that has always been important to a floor trader, yet been greatly overlookedby technicians; it offers great opportunity for research. Event trading, which studies mar.ket reaction to price shocks, has become increasingly important for both proactive andreactive traders; contrary opinion takes the form of a poll or consensus of opinions oftraders and market publications. It may help answer the question, “What is everyone elsedoing?", or at least, “What are they thinking of doing?” ; ; ; ;The principal works of Elliott and Gann are included with a review of the Fibonacciseries and ratios, which form a significant part of their technique. The way in which tradersrespond to market moves, and the remarkable similarity that can be found in Nature, giveserious underlying substance to these methods. Because not all of the assumptions uponwhich these systems are based can be quantified, they are substantiated by the perfor-mance of the systems themselves. Both are fascinating and open areas of creativity essen-tial to broad system development. They are grouped together with discussions of naturalphenomena and the rapidly growing area of financial astrology, all of which should leaveyour grey matter stimulated.
T= are some approaches to trading that are directly dependent on human behavior
 
MEASURING THE NEWS
.
Ifyou can keep your head when all about you are losing theirs, maybe you haven't beard
the news.
Rudyard Kipling’
The news is one of the greatest single elements affecting free trade. As a medium, it carriesboth fundamental and technical information about all markets, directly or indirectly, and isindispensable. If not objective, the news services could materially alter any opinion by theinclusion or omission of relevant information. The impact of news is so great that a specu-lator holding a market position according to a purely technical system would do best notreading, listening to, watching, or in any sense being exposed to news that might be causefor deviating from the system. In a study commissioned by the Wall Street Journal, it wasshown that 99% of the financial analysts polled read the paper regularly, and 92% consid-ered it the “most valuable” publication they read.* ;
‘As an element of a trading program or as an indicator of its own, the news is invalu-able. If we could measure the impact of unexpected news, the importance of the WallStreet Journal or the wire service articles, the USDA crop reports and the CFTC positions
‘Adam Smith, The Money Game (Random House, New York, 1967, p. 48).2 Frederick C. Klein and John A. Prestbo, News and the Market (Henry Regnery, Chicago, 1974, p. 3)
MEASURING THE NEWS 335
reports,’ and the anticipation of news, we would have a better view of the direction of themarkets. But first we must be aware of the complications of analyzing the news. There is theproblem of objectively selecting which items are relevant and which sources are mostimportant. The most difficult problem is quantifying the news—how do you rank each itemfor measurement, and on what scale do you determine cumulative importance? Some newsitems are known to have a greater impact on the market—weather disasters, major tradeagreements, key crop reports—but these must be ranked against themselves and otherissues to produce a numerical system of analysis. On a single day, an address by the Presi-dent about foreign trade may be ranked as a +6, a meeting of the Federal Reserve a +7,unemployment a +4, the NAFTA Agreement a +3, a continued lack of rain in the west as a+2, large grain stocks as a 4, and a key article in the Wall Street Journal on the improved Rus-sian crude oil production as a 5, giving a net score of +4 to the news—interpreted as mod-erately bullish. Such a ranking scheme would be considered analytic in nature, because ittries to weigh relevance on a predetermined scale without knowledge of individual effects.
Klein and Prestbo attempted such a study by assigning values of 3, 2, and 1 to articlesin the Wall Street Journal of decreasing importance. Their interest was the stock market,and their work was straightforward and some of the conclusions general in nature. Theyshowed a direct correlation between the relevant positive and negative news articles andthe direction of the stock market. As it was scored over 6-week intervals before and aftermajor turning points in thé Dow Jones Industrial Averages, the news would stay about 70%favoring the current market direction. Having eliminated the possibility of the marketinfluencing the news, they could conclude that, in retrospect, the market reflected thenature of the news.
‘The focus of news that influences commodity prices is different from that which movesthe stock market, because it is limited in scope and often specific to the particular physicalmarket. News releases and economic reports are an implicit part of commodity pricing;newspaper releases become very important in the last phase of a long move, which is eas-ily seen when weather is a primary factor, but also when trade agreements are being nego-tiated. For example, traders will watch the weather report beginning in June when therehas been a shortage of rain. They will stay long while no rain is in sight and quickly sell ifa thunderstorm develops over the Chicago Board of Trade building. They will also protecttheir positions going into the weekend, in the event of unexpected rain, then reset theirnet longs on Monday. The news items that affect prices the most are:
Release of economic statistics (inflation, sales, balance of trade, unemployment)Action by the Federal Reserve or other central bankNews relating to the availability of fundsGovernment reports on production and stocksUnexpected news (a potential price shock such as an assassination)“Trade negotiations, agreements, and legislationWeather ~ _In-depth studies by the Wail Street Journal .
Front-page news articles (or lead televitopics with a direct economic impact
 
n news) on high prices, strikes, and other
Market letters, research reports, and comments from accepted authorities and influ-ential organizations
>A thorough analysis of the CFTC Commitment of Traders report can be found in Chapter 16. It should be notedthat other government reports released on the same day may complicate the interpretation. 
 
336 BEHAVIORAL TECHNIQUES
Ranking and Measuring ~
The problem of ranking and assigning values to news items requires a knowledge of howothers see the news. Klein and Prestbo studied this problem for the stock market and con-cluded that about 90% of the Wall Street Journal readers perceived news in the same way(bullish, bearish, or neutral). The same relationship can be assumed for futures markets. Ateason for the uniform interpretation of the news articles is the publicized analysis. Withinminutes of the release of an economic report or Fed action, the wire services begin toquote independent and poll opinions of the meaning of the report, then transmit thoseinterpretations over their news media to be relayed to most traders. The professionalanalysis is taken as correct, and later discussions based on that interpretation serve tosolidify the opinion.
News can also be measured empirically, by studying the immediate impact of anexpected or surprise news item. For statistical reports, such as the Producer Price Index,care must be taken to use the correct figures. Market reaction is a combination of expecta-tions compared with actual figures, and corrections in the previous month's data. In somemonths it is difficult to know whether the jump in prices was due to a downward revisionof the previous month, or current values that are lower than expectations. When testingthese factors, the historic data must include the actual numbers released in the reports,and a separate value for the revision of the previous month. Industry expectations gre alsoimportant, but they can be determined empirically from the market's reaction. Therefore,following the release of an economic report, we can expect the price change to beexpressed as: .
Price change = f(a(current value - expectations) + b(revision — previous value))
where @ and 6 are weighting factors, a > b implying that the current value is more impor-tant than the ‘previous one. It is necessary to make the assumption for this type of mea-surement that the effects of a news release are most important in the short term, and thattheir influence on the market is diluted daily. A starting point for representing the way inwhich the news decreases in value is to modify the standard physics formula:
1oP ,where /is the net influence