Sign up now to receive our free newsletter
Managed Futures Strategy Focus: Spread Trading
July 9, 2007
While not everyone will admit it, I would bet that more people than not have woken up in the middle of he night thinking they've found the perfect way to guarantee they don't lose money - by buying and selling the same thing at the same time. It takes a while to explain to these people that the positions would be offset simultaneously, resulting in neither a gain nor a loss.
But there is something worth looking at with this thinking - of being long and short the same market simultaneously - and that something is not caring whether the market goes up or down, or being market neutral. One type of market neutral strategy being employed by several of Attain's recommended CTA programs is Spread Trading.
Spread Trading is the simultaneous purchase and sale of something very similar, economically speaking. In commodity markets, that usually means buying one contract month of a market while selling another contract month of the same market. For example, buying July 2007 Corn futures and selling December 2007 Corn futures is a spread trade.
Depending on whether you buy or sell the spread - the goal of a spread trade is for the difference between the two sides of the trade to either get further apart or closer together. In our example above, you would want either July Corn rising faster than December Corn does, or December Corn falling faster than July Corn.
Doing a spread with different contract months of the same market is called a Calendar Spread, which are really a phenomenon unique to futures markets, as the same futures market (like Corn) has many different contracts based on when in the future they expire. (Corn has different contracts which expire in March, May, July, September, and December each year). There is no such mechanism in the stock market. For example, you can't buy the July IBM stock and sell the December IBM stock - there is only the stock and whatever price it is trading at.
There are other types of spreads which buy and sell different markets simultaneously. Some of these are in markets very closely related - such as buying Soybeans and selling Soybean Oil or buying Crude Oil and selling Heating Oil. Other spreads may be in less obviously related markets like Corn and Wheat, or Two Year Note futures and 30 year bond futures. Any time you hear about the Yield Curve on the news, that is really the spread price between different interest rate products .
One of the biggest appeals of spread trading is that it can reduce risk, with the potential for losses on one side of a spread trade to be hedged by gains on the other side. Another benefit is that the margins for holding a spread trade are usually much less than the margin required for putting on an outright position. This isn't to say spreads have no risk - the two sides of the trade can and will go in completely opposite directions form time to time, which can cause substantial losses.
From a trading system or CTA perspective, spreads are attractive because the spread price tends to have more seasonality than outright markets, and the movement in spread prices tends to be a little less volatile and a bit more "trendy".
In Europe - Spread Trading means something completely different, with it being another name for spread betting. Spread betting is essentially how mainly UK citizens can go short stock, indices, etc., as tax and other laws make it prohibitive to short stocks as we do here in the US. Spread betting should not be confused with spread trading as we are discussing it here, as they are completely different.
Spread Trading CTAs
Attain has three programs on our recommended list which specialize in spreads exclusively. They are Chicago Capital Management's Spread Arbitrage program (aptly named) and NDX Capital Management's Shadrach and Abednego programs.
Many readers of this newsletter will be familiar with NDX Capital - which burst onto the scene last year with gains of over 100% in their Shadrach program (past performance is not necessarily indicative of future results) putting NDX at the top of many lists ranking CTAs.
NDX has one trick, and one trick only in both their Shadrach and Abednego programs, and that skill is spread trading the Hog markets, Lean Hog futures to be exact. NDX uses both discretionary and systematic methods to decide when and where to enter their spread positions, and they trade on both sides of the spread, sometimes looking for it to expand, sometimes to contract.
The discretionary methods used are based in pattern recognition and the advisor's pinpointing if seasonal trends will play out in the current year, and if so, when they will start and end. The systematic methods are proprietary and haven't been revealed to Attain, but we know they do use some Advanced GET logic
Chicago Capital is a much more diversified spread trader, participating in several different markets such as energies, grains, other agriculturals such as Cotton, and meat markets such as the Lean Hogs NDX trades.
The general strategy employed by Chicago Capital is to measure the spread differentials in these various markets to see whether any are outside of their "normal" range. Upon identifying a market which is outside of its normal range, in their opinion, Chicago Capital then makes a discretionary call of whether or not there is an economic justification for the spread to be outside the normal range.
If they decide there is no justification, they will place trades which will do well when the spread between the two markets or contracts returns to its normal range (and poorly if it doesn't return to the normal range). Chicago Capital will also trade inter-market spreads, meaning the simultaneous purchase and sale of different markets, such as buying Wheat and selling Corn.
One final note on Chicago Capital is that they have completely deleveraged their program, resulting in it using very little margin - with their average only about 7% of the $100,000 minimum account ($7,000) This makes Chicago Capital an ideal candidate for notional trading, with investors only needing between $25,000 and $40,000 in cash to trade the $100,000 minimum program. That of course means percentage gains and losses will be much larger, and the fees will be a much bigger percentage of the cash value of the account (but the same on the notional value = $100K).
An example of the performance when trading Chicago Capital at 4 times leverage, that is - putting up only $25,000 cash to have it traded like $100,000 - is below. The percentage gains and losses are on the cash value of the account, not the notional value, thus are exactly four times what you see on the main program's monthly values.
This ability to notionalize Chicago Capital, paired with NDX Capital's flat performance, reduced trading, and small margin requirements this year makes for an interesting trading idea for those who are growing impatient waiting for NDX to return to its winning ways.
The recommendation is to trade both programs with the investment currently allocated to NDX. For investors who have $50,000 with NDX - this would entail putting up the $50,000 cash to trade at 3 to 1 leverage as a total of $150,000 ($50K with NDX just as before, and $100K with Chicago Capital).
This may seem very aggressive to many, and it is important to realize that you will be charged fees and trade at levels on the full notional value ($150K) - but the metric the clearing firms use to measure the riskiness of the approach (the margin requirement) tells us that it is not overly aggressive - with current margins on the combined portfolio less than $10,000.
Astute investors will say what happens if the margin increases and the combination becomes more aggressive than they are willing to take on, and that is a great question. The answer is you would then have to choose between the two programs, assuming you haven't made enough money to cover the margins for both or enough money to bring you a comfort level. If and when the Hog market returns to patterns which enable NDX to put on more positions and return to their 100%+ annual returns, then you may want to drop Chicago Capital, and if NDX never does return to those levels - then you would drop them and stick with Chicago Capital.
At the end of the day, combining the two gives you continued exposure to the spread trading strategy which is completely unlike the option selling and directional strategies used elsewhere in the CTA world, while at the same time diversifies your investment within spread trading by adding several other markets to NDX's lone market approach.
IMPORTANT RISK DISCLOSURE
Not on our mailing list? Sign up now to receive this weekly newsletter.
With many traders on summer vacation in the US, stock futures crawled higher last week on very light volume caused by the Fourth of July holiday. For the week SP futures climbed +1.79%, NASDAQ futures were up +2.71% and Dow futures rallied +1.41% higher. In smallcap trading Russell 2000 futures moved +2.01% higher and SP Midcap futures gained +2.28%.
Energy trading also came into focus last week as millions of Americans hit the roads despite higher than average gasoline prices, with RBOB Gas futures gaining +2.98% last week. Crude Oil futures +3.01% also climbed higher as did Heating Oil futures which were up +2.58%, while Natural Gas futures continue to head in the opposite direction losing -4.51%.
Elsewhere the grain complex finally calmed down after a month of raucous trading. The markets climbed higher last week with Wheat futures gaining +2.18% and Soybean futures gaining +1.62% however the volatility that has dominated the grain markets of late finally dissipated. Corn futures ended the week unchanged. Other markets in the news include Coffee which fell -2.70%, US Bond futures fell -1.54%, Cotton was up +2.50%, Silver climbed +2.25% higher, and Platinum gained +1.91%.
***Commodity Trading Advisors (CTAs)***
As expected with the independence day holiday in the US, the first week of July was rather anti-climatic for most world markets and in turn most CTA’s.
Option sellers were among the one group of managers who enjoyed the slow down, as they enjoy slow moving markets due to the fact time will slowly tick away during quiet times, meaning the time value of the short options they hold will erode a little by little. Among the profitable mangers for the week were Financial Commodity Investments, CKP Lomax, Zephyr Asset Aggressive and Aggressive, BC Capital, Diamond Capital, Zenith Resources Diversified and Index, and Ascendant Asset Advisors.
In other trading, out right and spread traders found the lack of volatility difficult to find a direction and ended down for the week; Dighton giving back some open profits, Phoenix lost on several false energy trends, NDX remained virtually flat on their small position, and Chicago Capital gave back some profits in the Cattle.
To view each CTA’s June performance, here is the link: http://www.attainaccess.com/cta
***Day & Swing Trading***
U.S. stocks inched higher last week on light volume - limiting day trading activity and giving swing systems a small boost for those that are holding long equities or short bonds.
Adaptive Euro was the top system across all systems, profiting another +$4,854 after closing out some long trades that it entered the week prior. Of the US-based swing systems, Tzar ES and Targets eRL were both leaders of the pack with profits of +$1,195 and +$1,190. SeasonalST eRL and ES came back to life after a slow Q3 with profits of +$1,010 and +$902.50 respectively. Adaptive US tacked on another +$514.09 after closing out some winning long trades.
Mesa Notes finally got back to its breakeven point on its current short position by making back +$765 in open trade equity last week as the Ten Year Note head back toward recent lows. Tzar eRL followed the path of the ES system by reversing short on Tuesday and made +$590 for the week. Tzar NQ followed suit but lost -$50 net on the week. Ultramini eMD and Ultramini YM have been steady performers in the high volatility environment of the past few months, but still managed to profit +$420 and +$392.50 despite slower conditions.
Elsewhere, day trading systems barely had a pulse with S&P trading in less than a 15 point range for the shortened trading week. Impetus eRL had one long trade on Monday that made +$29 while OPXP had one short trade that lost -$40. Both systems that were active in the Dax market- Rayo Plus and Phi Plus- took losses of -$614.29 and -$649.66 respectively.
Rate futures posted moderate losses during the past week as the sector fell from 1+ month highs on better than expected economic data along with pressure from profit taking after a decent 3-week rally. The main news in the sector continues to emanate from the sub-prime mortgage fiasco which has sparked underlying support in the sector, but it was overshadowed by the stronger economic news that rekindled inflation worries. Economic releases for the week ahead are fairly light, although Fed Chairman Bernanke will speak on the subject of inflation and economic progress which will probably push the housing and mortgage risk to the back burner for a couple of days. Currently long term trend followers remain in a down bias as Aberration is short the Sept. Bund currently making +3,490.00 Euros (open trade) as well as a short Sept. TY position with a current gains of $1968.75 (open trade).
The major European currencies ended with moderate gains last week as strong economic and manufacturing data help spark ideas that an increase in Europe rates would be forthcoming bringing with it a wave of foreign investment. The Japanese Yen continued to find pressure from the stagnant Japanese economy and the U.S. Dollar was pressured by thoughts growth had slowed enough to warrant steady interest rates for the foreseeable future. Long term trend followers remain on the sidelines due to choppiness and volatile swings as Aberration was stopped out of the short Sept. SF with a loss of -$1650.00.
Soft commodities were a mixed bag last week, although most enjoyed support from changes in production and better than expected demand during the holiday week. The grain sector saw soybeans score new 2+ year highs on reduced plantings and wheat move to new 8+ year highs on crop problems world wide not to mention very tight world supplies. Worries of crop stress waned as rains did find there way to the driest regions of the Corn belt, although it will take more to kill drought worries. Activity in grains and oilseeds for the upcoming week should be fairly subdued ahead of Thursday’s monthly report releases, although as always any change in weather forecasts could spark volatile activity. Aberration is currently long BOZ making +$1762.00 (open trade), Short SBV losing -$206.80 (open trade) and Long KWU making +$1800.00(open trade).
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.