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Track 'n Trade Futures End of Day Spreads

Inter-Market Spreads

Video Transcript

Scott: Lan, in this section, we're going to cover Intramarket, or Delivery spreads. An Intramarket or delivery spread is established by the simultaneous purchase of one delivery month and the sale of another delivery month of the same commodity of the same exchange.

Lan: That's the important key point, right there. Intramarket is the same commodity on the same exchange.

Scott: Right, these are your Chicago Board of Trade Wheat, like buying a July Board of Trade Wheat contract vs. a December Board of Trade Wheat contract. Or July Corn to December Corn. April Live Cattle to August Live Cattle. Same commodity, same exchange. This is the most common type of spread transaction done. The volume done on these delivery spreads accounts for a good portion of the daily trading volume on the floor, all major exchanges.

The dominant factor in this type of spread is carrying charges. Carrying charges are the combined costs of storage insurance and interest. Some futures markets do not have carrying charges in the standard sense of it; like the financial markets. You don't store Canadian Dollars.

Lan: Yeah, let's talk a little bit about what a carrying charge is. Carrying a charge is basically on a Wheat market is like rent on the storage space that you're using to store your wheat, right?

Scott: Right, for example, to store corn or wheat in a Chicago Board of Trade recognized warehouse it's about 3.5 cents per month on the current. So, they're going to knock off whatever sale price they're going to charge you 3.5 cents per bushel, or per grouping of bushels. Now, we add in a little insurance, you don't want to see the ‘What if your corn spoils?’ If it gets too moist, that type of thing. Just like you have renter's insurance when you rent an apartment- you insure your grain when you put it into storage.

We say interest rates on this, whether you own it or not, outright, you're looking at- there's a cost of keeping your money in corn vs. selling it today and sticking that money in the bank. Which is more valuable? Keeping your money in corn and not selling your corn right away as a farmer, you know, you're giving up the interest you could earn off of selling it right away, and sticking it in the bank. That is factored into what we call carrying charges, as well.

Lan: But the farmer does that basically because he wants to be long corn.

Scott: Exactly, he wants to hold out for a better price. He thinks prices are going to go up.

Lan: Now, Canadian Dollar, you don't have carrying charges per say, like rent to hold it in the bank, but they're basically paying you interest if you hold your money in the bank.

Scott: Exactly, you see where the further out months in corn, if you're going to buy corn today and we'll just assume let's say, we're in January. If I'm going to go out and buy corn today. So I'm looking at.. say March contract- it should be trading at a lower price than a later, like a July contract. Because you have several months worth of storage charges factored in there as well. So, the front month Futures on the physical commodities most the time the carrying charge, markets is what we call these, tend to trade at a lower price.

Let's look at for example, let's take a look at a physical commodity or a carrying charge market. Let's look at Board of Trade Wheat. On this particular day, the March contract was trading at 278 1/4, the May contract was trading at 284 1/4. We see a 3 cent differential in there. That's carrying charges. The July contract is at 287, 2 1/4 cents over. 291, again, notice how it stair steps up. That is what we call a normal carrying charge market. This is very common in the physical commodities.

Lan: Now, sometimes you see those get out of whack. You'll see it scoot back up to that top there. Sometimes you'll see where a September will actually be a smaller number than say May or July. Those will- some will have to be brought back into order. It's a trading opportunity for you to catch.

Scott: Exactly, but also, you know, that brings up a great point as so many of us tend to be strictly technical traders and then we're looking at something that's out of whack but we have a major fundamental reason why it's out of whack. In that case, that fundamental reason would be different crop years.

If we were looking at, for example, if we go down and we take a look at you know, the corn market here, the July Corn trading, you know a 224.5 represents corn in storage as we're right now in the month of July. While, if we go down to the December contract, that represents corn in the ground. That is the next following years, crop year. This is what we mean when you hear the old crop, new crop. The crop year marketing year for corn ends at the end of September.

So, for example: We would look at it in this case the July contract and the September contract would both be old crop contracts. While the December contract is the corn we see out in the fields.

Lan: So the carrying charges are going to be different.

Scott: Corn in storage, corn in the fields.

Lan: Based on whether the corn is in the ground or whether it's out in storage.

Scott: Exactly, and it doesn't always have to be different, but sometimes you get a case where we see we have a lot of grain in storage and the crop in the ground or future supply looks really bad. In that case, we're going to see not only our standard carrying charges, but in between that September contract and that December contract, we're going to see a big premium in there.

Lan: Based on the fundamentals whether it's going to rain, or whether they're going to be too dry. So you have more than just carrying charges between old crop and new crop to take into consideration.

Scott: Exactly, now, you could end with the opposite situation as well, of demand is running really strong. Maybe demand is running real strong, we've been obviously with demand running strong, we're using a lot of grain. We're taking it out of storage, but the stuff we just planted in the ground isn't growing well. It hasn't been raining, then we see what we call an inverted market. This is where normally today, if you're going to buy, you see that stair step in the physical delivery markets. The front month futures contract is trading at a lower price than the following, the next deferred contract out. They keep stair stepping up at a greater and greater price. Representing that cost or that rent to put that cost in storage.

Now, if you look at- oh, my gosh, we're using so much corn before we get that corn out of the ground and we see it come out of the ground, we're going to run out. Now you have the case where the bird and the hand is worth two in the bush. And you see this front month market trade at a premium to the back months. That's what we call an inverted market, and it does not represent carrying charges at all. This is where we have no grain in storage, but the crop and the field looks wonderful. This is a demand pull market. Normally, even if you're not a spread trader, you know, quote unquote, if you're looking at a physical delivery market that is normally a carrying charge market and you see it invert, that is a sign that prices are probably going up. This is a strong market, that we're looking at here.

Why don't we go and take a look at typically how these delivery spreads operate. Let's go over and let's take a look at some Corn spreads. This is a July December Corn spread for 2000, this would be an old contract, July Corn in storage vs. corn in the ground spread. We're going to look at this one vs. a corn in storage to corn in storage spread. We're going to look at this in the period of July August area down to the December. This whole little trend here. Let's just throw up our dollar calculator here. This move assuming, you know, obviously you're not going to pick exact highs and lows, but there's what we're shooting for. This is roughly a $750.00-$775.00 move.

Lan: That's over about 4 months.

Scott: Right, again, this is the corn market and we all know the corn market is a fairly quiet market. It doesn't move like Soybeans, or Cotton, it's not like trading the S&P, this is the Corn market.

If we were to look at the same spread that is an old crop to old crop spread. Let's go in and let's take a look at the December 1999 vs. May 2000 spread. We'll kind of look at that same period here. Again, we'll kind of pick that high right up here, down to that low and assume we were perfect. Where we made it possible for a $775.00 move to this old crop to old crop spread. It moved to about half of that, even less than that.

Lan: In about that same period of time, in about 4 months.

Scott: Exactly, they both moved in the same direction reflecting the fact that the corn market, by the spread declining, this is what would be known as a bear spread in the grain markets or selling the front month futures and buying a deferred contract. You'll notice that the December 1999 Corn Futures expire before the May 2000. So, front month, back month. The fronts decline more than the backs; the spread went down. That is a general indication that the trend in corn is down, or people aren't willing to step up to the plate and pay more for supply today. They would rather put it off.

Obviously, that's not a sign of a market that has strong demand or a market that you know the buyers are terribly aggressive. So, when you're looking at these spreads and these are the- typically when people say they're a spread trader, these are the most common types of spreads. These are your quiet and stayed spreads. These are the- the delivery spreads are the ones with the lowest margin requirements. They theoretically have the least amount of risk and you know, obviously risk and reward go together so they have the lowest profit potential, as well.

But not all delivery spreads are created equal. You have to look at and understand the production cycle of the commodity you're looking at, as well, to know is this an old crop, new crop spread. They can move. There are times I can remember looking and trading Soybean spreads, like a July November Soybean spread, which would be an old crop vs. new crop or beans in storage vs. beans in the ground and seeing July beans in the ground and seeing July beans go up 10 or 15 cents and seeing November beans go down 5 cents. That is a wonderful situation when you're long July and short November.

But if you are short July and long November you're getting nailed on both sides. To where- in that type of spread are these old crop to new crop spreads sometimes the risk may be greater than the risk of just trading an outright futures contract? Or just going long or short a bean contract here.

We have to look at and break these commodities down into- is this a delivery market, is this a delivery market, is this a carrying charge market? Is this a non-carrying charge market? You can generally make that assumption on is it a physical commodity or not? Let's go in and let's just kind of take a look at some of the futures prices. Let's skip over the-

Lan: I want to make a quick comment here before we go onto the next section here Scott. It's very important that we realize that trading spreads really does have a lot to do with the fundamental nature of the markets. Knowing old crop, new crop- knowing whether you're spreading an old crop to an old crop or a new crop to a new crop. Whether you're spreading a bear spread or a bull spread. What that means, and why you have one contract ahead of the other.

The fundamental nature of the markets is very important in trading spreads, not so much the technical nature. Now, we can trade spreads using technical analysis. We're going to go through some examples where we're going to show technical analysis on a spread chart. But we have to know and understand the underlying fundamental nature of the market first. It's not just simply, ignore all the fundamentals and let's just look at the technical formations, like we do when we're looking at a standard futures contract and we're just looking for recurring price patterns.

Scott: Right

Lan: We need to understand the underlying futures nature of the futures market.

Scott: It's kind of like when you're an outright futures trader, you pick your commodities if you really like a market that moves a lot. You might trade cotton as volatile. How about coffee and cocoa? But if you prefer markets that move a little slower, you might trade the corn market, except during the 2001 2002 period you might trade Oats. You might look at Eurodollar Futures., the interest rates, not the currency one. These are quieter markets vs. more volatile ones.

You like volatile, you're trading coffee, lumber, pork bellies, platinum, cocoa. You like less volatile, it's the same thing in the spreads, except the designation in the spreads is you have to understand that natural production cycle the crop years are: is it old crop vs. new crop?

Now, we go through here at Gecko and in that you can get a good understanding of that looking at the Gecko Seasonal newsletter. Why don't you tell us a little bit about that, Lan?

Lan: Well, we've hooked up with Scott here as CFEA and we've pulled together this newsletter here, that allows us to not only give us trade recommendations on a seasonal nature, but it also comes through and gives you the fundamental nature of the markets that we're talking about in each given month. We've pulled together this newsletter that comes out every month it's about, you know, about 25-30 pages long sometimes. It gives you an overview of each commodity that we're looking at throughout that month. We review reports that are coming out, government reports. We tell you the nature of the different markets plus the seasonal nature and the seasonal trade recommendation.

It is a fantastic newsletter, which is going to help you not only in your spread trading, but with your seasonal trading and fundamental nature of each market, and knowing what the reports are going to do.

We try to give a little insight in that newsletter that tells you how we expect the reports the government reports that are coming out to affect the markets. So, it's a fantastic newsletter, and it's- I mean, we're almost giving the thing away!

Scott: I was going to say, plus you get a chance to look over Lan's shoulder and look at the charts he's looking at, and what type of analysis that he's doing on the charts, as well as the more fundamental and seasonal analysis, that I do.

Why don't we kill the sales pitch here and get back to talking about the carrying charges. We look at, and we understand Corn that works in that storage. Cotton is not that much different Cotton is grown in a field, etc.. You see the same type of thing in the Cotton market. Look at the July contract 46.05 October 47.05, it progressively goes up representing carrying charges.

We go down and we take a look at the coffee market. That's not even grown in the United States. But it has a crop year, and it's stored. Coffee represents the same basic pattern of that stair stepping. That is a typical and a normal pattern. It is an abnormal event when you see the- in these type of markets, the carrying charge markets, you see the front month's trading at a premium to the back months, or an inverted market.

Lan: That's where I'm saying that there's an opportunity to possibly find a trade, because you.. those are going to have to come back or generally are pulled back into sync with the front months being less than the back months.

Scott: Exactly, and you typically see that around the period of the switchover from old crop to new crop. But it's reflected throughout the market. Sometimes these can get really out of whack. Now, generally when this happens, when- so when you're looking at these carrying charges of spreads, you want to see how large is the remaining supply carry over from the last harvest? Will this carry over be enough to meet current demand until harvest, or is there fear that we could run out of the grain before it's harvested or the physical commodity? What is the outlook for the size and quality of the new crop? If the new crop is looking especially large or small, then this can have a dramatic effect on prices and the spreads.

A large future supply can pressure prices, while a small futures supply can you know, pump up the different contracts. We can see these inversions, and these inversions can last a long time. They do come back into line. As the old saying goes: Markets can be irrational, but markets can stay irrational longer than traders can stay liquid. This is where your technical analysis comes in. Look for that shift in.. this has gone out, it has broken that normal pattern. We're seeing the fronts trading at a premium to the backs and we're seeing that go beyond that rollover, but there are still people that store commodities and they like to get paid. They're going to do everything within their power to bring that back into line. They want to make those carrying charges.

You look at, how does the rate of usage compare to previous forecasts. Is the USDA raising exports and usage numbers each month, or are they decreasing usage? What is the outlook for future demand? You really have to kind of take a look at all of these fundamental factors as well as just looking at the spreads.

Why don't we pop back and take a look at some of these spreads? We can go and take a look at Coffee, which is an extremely volatile commodity. The spreads in it, because coffee production is spread out all over the place and you have a lot of different crop years and different times that they're bringing in the coffees. You tend to see a lot less volatility in the spreads than you see in the coffee market itself. Again, you have the same basic pattern of, if you are bullish on coffee and you think the spread is at an attractive price, you can buy a front month and sell a back month; bull spread. If you think about coffee is over overvalued and you think the spread is overvalued, you can bear spread this, or buy a back month and sell a front month. But looking at coffee here, seeing- again, we're looking at about a 4 month period, we're seeing an $850.00 move vs..

Lan: Now, coffee is a contract that is quite large. So, a lot of new traders are unable to trade it because of the high margin. Going into it with a spread would make it more, make it possible for a newer trader to be able to trade the coffee market. I like the coffee market, it trends well. I mean, you can- it's a very nicely trending market. You can often times see recurring price patterns from a technical standpoint. You can, it's in the news, you understand that things are happening with the coffee market, because it is a big market. So it has fundamental news behind it as well.

Scott: Right, and coffee is a market that coffee consumption, coffee and sugar both share this habit of the demand portion is very constant.

Lan: But due to its size, it keeps a lot of beginning traders out of it. Spreads gives the opportunity for a beginning trader to come in and you know, look at the coffees market.

Scott: That same period, you know, we're looking at almost a $10,000.00 move in the outright futures contracts. You can see here, and it went down. But if we go back and we look at that coffee spread, we saw 1/10 of the move. It's like getting a good liquid mini coffee futures contract within the spreads here.

Lan: And without the huge risk that you have in the outright market.

Scott: Exactly, you know, you're not going to see a spread market lock limit. Because both sides of the spread can lock.. you know... you're- if the market goes straight up if they both go limit up, if it goes limit up, end of July, then December is probably going to go up limit, or close to it. You're partially hedged.

You see the same thing in another volatile commodity which is cotton. Again, you're able to trade the- and this is what we're looking at here is an old crop new crop. So, this is going to be a very volatile spread. In over a period, you know, we have a $2,200.00 move. We have a very short term move here, about $850.00. We have a lot of breaks of support on this to look at from a technical standpoint.

Lan: One of the points I want to make is that a lot of these markets are globally produced; because of that, we were talking about old crop new crop stuff, sometimes the old crop new crop effects do not take effect quite so much in some of these crops like we're seeing here in Cotton, that are globally produced.

Scott: Exactly, and you'll also see times that as we are very- when we think about the futures markets, you know, we look at US weather. We're looking at the US situation when this is a global market. So, we could see a bad US situation but a good global production.

We had terribly dry weather, or terribly wet weather to prevent planting in the southern, in the cotton belt states. Here in the US, but India and you know, Russia, and you know, a lot of your other major cotton producers, you know, they have beautiful crops. You'll see sometimes these scares that occur and really occur in the spread market, can be taken advantage of very well in the spread market And the spread market will return to rationality ahead of the futures market and you can withstand the craziness a lot more because it tends to move less.

Lan: And because we are- the markets have a tendency to react quickly to U.S. conditions, but then because we are a world market, they have to correct taking into account the other part of the world that's generating this same type of commodity.

Scott: Exactly, but again we're looking at situations where we can trade a spread with a lot less risk and obviously less reward, but still these spreads move enough to definitely make it worthwhile. Now, if we kind of get out of the true carrying charge markets and let's look at another agricultural market that's not quite a carrying charge market, it's not a crop.

Why don't we go and we'll take a look at the Live Cattle market. Within the Live Cattle market, this is a true spreaders market, the livestock markets are spread way more than they're traded outright. Because you have pockets of production. But typically when you're looking at this in the same rules for a bull and a bear spread apply, if you are looking at cattle prices going up in general across the board the front month futures should gain more than the back month futures.

Lan: Kind of the seasonality of this market, of the livestock market is that you have, you know these people have produced animals, they don't want to carry them through the winter time. It's a lot more expensive to feed, so you have they have the drawdowns of the crop, if you want to call it the crop or the livestock is during the winter time. So, when you spread, you want to spread winter time vs. summer time.

Scott: Exactly, in fact, I know Lan, you come from a bit of a ranching background yourself. You're kind of a gentleman rancher in the back 40 of your house. Here in Utah I would assume pasture conditions are not terribly conducive to that in the middle of December, are they?

Lan: No, sometimes you start getting some dry years, like we're having in this last little while. You start getting some troubles feeding your animals late in the summer. You can't get the feed to come up due to lack of water.

Scott: Exactly, all of these factors affect it, and they'll affect delivery and you'll see a lot of cattle being brought, what they call pull forward, or maybe pushed back. If a cow calf operator- the people that breed and actually produce calves, they'll try to breed them and get them birthed in the early spring so they can put them out to summer pasture, before they stick them in the feed lots. They'll wait hopefully then they'll get good prices in there.

Now, you have your feed lots that are- they're in the business of fattening these. This is why we call Live Cattle fat cattle. They buy the feeder cattle, they shove corn down their throat, bring them up to slaughter weight and sell them off, pretty soon, they're a burger and a t-bone, we all enjoy. If they see that there's no supply coming in and they prefer to try to stay full. They're in the business of fattening cattle, they want to have cattle within the production process. If they see that land is getting dry and more and more the cow calf operators are selling to them, they have to sell the cattle they have on feed to make room for the new ones they're bringing in. You can see where, instead of trying to fatten them up to the upper end, they might try to get them out a little sooner. There are times when they're not getting them brought in, they're going to try to get a bigger price, or a bigger weight on them and they put it off, because they don't want to be running empty production capacity.

You see, if you look here, you'll see kind of the structure of the pricing of cattle, you kind of see we have an August at 64.47, then we go to 66.60, we see a bit of a carrying charge. Then, that carrying charge just drops off, it just disappears here. Right in between the April and the June, you have no cattle available or a lot less, because they don't like to feed them throughout the winter, because it costs more. They put on weight slower. You have to bring in, you can't feed them the grass that's not available. But then as we start getting into June and August, there's more available, prices are lower. You kind of have to understand that and see that this is not a normal carrying charge market in the cattle.

As you're looking at these, you're going to want to go over your history of your spreads within Track 'n Trade, and look at it. Does this market normally trade at a premium? This spread, does it normally trade at a discount? Is it typical to see April Live Cattle to be 6-7 cents over June Live Cattle? Is this spread real deer or is it really cheap? This is the same principal we look at when we trade an outright futures contract, except we don't care about the absolute level of Live Cattle, we care about looking at how is the absolute level of April Cattle relative to June Cattle, the spread, not what are cattle prices, what are beef prices.

Lan: We also want to know the fundamental reason why April is deer or premium to June.

Scott: Exactly! Look at your history and test things. Now, when we get into other markets, or what I tend to call your non-carrying charge markets. You can look at- let's start off with an interest rate, because that's an easy one to understand for all of us. When we- I'm looking at Eurodollars here, and Eurodollars are time deposits. These are like CDs, they just happen to be a CD that is U.S. dollars held in a foreign bank. But it's an interest rate. When we go down to our local bank and you're looking at a 3 month CD, you're going to get an interest rate of, let's just say a 2.5%. But if we look at a 1 year CD, Lan, is that interest rate going to be higher or lower than our 3 month CD on a 1 year CD?

Lan: Well, CD's, you're going to get a higher interest rate because they get to hold onto your money longer, and then they get to do more with it themselves.

Scott: Right, so, typically in the Eurodollar market you're going to see the front month futures contracts trading at a higher price than the back month futures contracts. Representing that differential interest rates. If you walk down onto the trading floor onto the Chicago Merck and you take a look at Eurodollar market, you know, that pit is about the size of a football field. It's broken up into segments. In this little segment we are trading the front month. The next segment we are trading, you know, the following month out.

The spread market is so active that a lot of the firms have taken to hiring these basketball players. They're hiring basketball players to do it, because these guys are tall enough to look over the crowd and they can be trading a front month and they spread it against a back month and they can see the guy in the back month and they can do hand signals to each other.

Lan: They have great big hands that they can flash all their signs.

Scott: Exactly, so you can see across a football field what this guy is doing. These spreads represent interest rates. In differentials and interest rates. The exact opposite rule applies in the physical commodities or carrying charge markets, you know, a bull spread would be- buy the fronts, sell the backs. In a non carrying charge market, like the Eurodollar market or the financial markets, we see a bull spread is buy the backs, sell the fronts. You want to get a higher interest rate. You go out to a year CD, it's going to be more volatile; it will move more. Looking at this spread, which would be a December vs. a red December or a following years December. This is a very popular calendar spread or delivery spread within the Eurodollar market. If you are bullish on Eurodollars or you expect interest rates to drop, you will buy the distant contract and sell the front contract. Now, if you expect interest rates to go up, you would do the opposite. You would buy the near term contract. Now, if you expect interest rates to go up, you would do the opposite. You would buy the near term contract and sell the back deferred contract, because it will fall in value more than the front month in most cases. These are just kind of general rules of thumb, they don't always hold.

Sometimes in the interest rates, and we haven't seen it for years, I want to say decades, we see what is known as an inverted yield curve. Anybody that can remember back to the 70's the mad inflation, you saw that. You saw where short term rates were up near 19%. But if you wanted to look at a 30 year rate, you were paying 12%. So, if you wanted to borrow money for a year, you paid 19%. If you wanted to borrow money for 30 years, you paid 12%. In this case, you would see the front month's trading over the back months in the Eurodollar market, or the bond market. T-bills, the notes, those types of markets. But typically this is a semi-rare occasion. This is kind of like what we were talking about with inverted markets, or in the carrying charge, that would be known as an inverted market within the non-carrying charges- charge markets. They're temporary situations.

Just like the other ones, they can last longer than a lot of us can stay liquid. Meaning we all realize that the normal state of interest rates is the longer you borrow money, the more risk involved, the higher interest rate you pay, or the higher interest rate you demand from it. But that can really get out of whack and stay out of whack for a long time. We look at the same type of thing..

Lan: Well, and it's because of those out of whack situations where we take advantage of them in the futures market and what these spreads, and we're able to capitalize on them, and we're able to make money.

Scott: Right, and though there is no crop, there's no crop within the interest rates, I'm sure bankers tend to kind of think of a crop year- that there really isn't. You know, if you look at, if we looked at instead of a December vs. a red December let's look at just a 6 month. Let's take a look at the March 2001 Eurodollars vs. the September 2001 Eurodollars. We're not seeing nearly the amount of move. But still, even this 6 month spread, tends to move fairly well.

This happened to be a very volatile time for interest rates. You still over a four month period had the ability to make $1,500.00 in the Eurodollar market. Now, that would have been probably closer to the $3,000.00 within the straight futures markets. But on a Eurodollar spread, you know, you're looking at margin rates that for this type of spread are probably going to be a quarter of it. You're seeing, maybe, in this particular case where the yield curb really flattened, or the differential between a 3 month CD and a 9 month CD got a lot less. That would be known as flattening the yield curve. They're moving together, it flattened a lot more than the level of interest rates change. You're looking at a quarter margin and half the move vs. 100% margin in twice the move. Actually, in this case almost trading the spread, you're getting a bigger bang for your buck!

Lan: The advantages of trading spreads.

Scott: Exactly, look at that trend, I mean it's rare to see a trend that beautiful and you're looking at small drawdowns. I'm saying, Lan even you who is a terribly quick, of I want to take my profits and I don't deal well with drawdowns, I think even you could sit through $112.50 draw down.

Lan: Yeah, this is not a bad one, here.

Scott: We see a slightly larger one down here, oh gosh, it's almost a $200.00 drawdown. Take a look at some of the indicators on there.

Lan: That's a Stochastics right there that you're looking at.

Scott: Yeah, you know, and if you were to look at something along these lines of this market got- you'll see this within trading spreads and looking at things like the indicators. Spreads is one of the advantages of spreads, they tend to trend. So, you have to tend to stick to your trend following indicators as opposed to your overbought or oversold indicators. Because you're going to see a lot of.. kind of this mess.

Lan: Where they just hang down in the oversold regions for a long period of time. But that's alright, I mean if you know that, you can look at that and you can say, okay, I'm trending down on my Stochastics. And when it comes up out of that oversold region, that's an indicator for me to jump out of the market, or start placing a stop.

Scott: Right, now, if we look at another popular financial market, you know, let's take a look at the S&P. The S&P has a spread to it as well. The S&P has a carrying charge feature to it, and that carrying charge feature is let's discount back. I'm old enough to remember when most stocks paid a dividend. I realize in a lot of the newer companies have chosen not to pay dividends, but the S&P 500 companies- a lot of them do pay a dividend. We have to- if we hold a March futures contract and this company pays a dividend in February, we don't get that dividend as an ownership of a futures contract. So, we want to take that price that's implied to the underlying cash market and take it out.

We also have tied up our money. We're not earning interest on it again. We have that whole interest carrying charge in there that we're not getting either. But you can see that you can look at, and the general rules would be for the S&P is the same as the Eurodollar. If you want to bull spread it, you buy a deferred contract and you sell a near term contract. We can look at this period where the stock market was getting hammered and we look at the spread and the spread moved. The spread almost went in a straight up trend, and the stock market almost went in a straight down trend.

Trading the S&P 500, I want to say that margin rate on a straight futures contract is somewhere in the ballpark of $20,000.00-$30,000.00 initial margin per contract.

Lan: Obviously, that makes it so that new traders are really just pretty much taken right out of the market. You can't trade that one with a beginning account.

Scott: Exactly, even if you go to the S&P E-mini, you know, you're looking at a $2,000.00-$4,000.00 margin in there. It's 1/5 the size, it's 1/5 the margin. But looking at this spread, you're looking at margins that are dramatically cheaper in here. To where maybe not a terribly under-capitalized trader, but a- you're probably looking at spread margins in the ballpark of, you know, about $1,000.00.

Lan: Which makes it more appealing to a lot of people who really look and follow the S&P 500. Now, with the spreads you can actually jump in and start trading that market.

Scott: Exactly, and you can trade that market on a longer term basis instead of a day trading basis.

Lan: Which is what most people do that I'm familiar with, anyway. They trade the S&P on a day to day basis. So, the longer term traders are able to take advantage of that and stay in the market longer with the spreads. Another advantage of trading the spreads.

Scott: Exactly, you know, and if we take a look at all of these, these draw downs were terribly small. Basically, in general when you're looking at the delivery spreads, you have to understand is this a carrying charge market or is this a non carrying charge market? In the carrying charge markets, you're kind of implicitly being bullish the absolute price by buying the front month and selling the back month. You should see in the normal conditions the front month trading at a lower price than the deferred contracts. You'll see it gain. While in the non carrying charge markets, which are typically your financial markets- you tend to see the opposite situation. You see opposite of bull and bear spreads. A bull spread in the financials are non carrying charge markets is going to be buy of deferred contract and sell a near term contract. In the S&P, you know, buy the June for a bull sell the March. For a bear spread would be buy the March, sell the June. Buy the near terms sell the deferred if you think that prices are going to go down.

We have one other market that kind of doesn't fit any of the situation of it's a carrying charge market or it's a non carrying charge market. That is the Crude Oil market. We kind of think right away the Crude Oil is a physical commodity, but it's a.. almost a financial commodity as well. Really, why it's not a carrying charge market, crude oil is very storable, but there is not- when you look at a refinery they tend to run at capacity.

Lan: They don't want to hold on to that stuff any longer than they have to.

Scott: Exactly, they tend to produce to keep their stuff full. Now, if you go and you look at how the distribution network was and Lan, I know you grew up and your father was a distributor of fuel.

Lan: A distributor job, he was in the whole line.

Scott: How long would he store for?

Lan: As little as possible, you wanted to have just enough to cover your needs. Barely enough to cover your needs.

Scott: Right.

Lan: You didn't want to have this extra stuff laying around on hand.

Scott: This is kind of what we referred to a lot as "just in time" inventory. Isn't that their catch term for it? Within that process, you see that major changes in demand or supply for crude oil can really affect the futures and the spreads.

Why don't we take a quick look here at we'll say maybe a... we'll look at buying February Crude Oil, and we will sell maybe a June Crude Oil. Oh, I passed by it here. We'll go to June 2002 Crude Oil. You're going to see, you know, Crude Oil is another very volatile market but within the spreads it kind of brings it back down to line. But still those spreads move a whole lot. We have a $1,700.00 move, which is only $1.70 move in the price of Crude Oil, which is not terribly outrageous. But this brings it back into the realm of affordability for a- at times a very quiet commodity but at times an extremely volatile commodity.

You can look at kind of one of the general rules of thumb within spreading in the crude oil market is especially as we all look for- I've always considered the crude oil market to be a barometer of worldwide tension. Many people look to Gold being that and with all the problems that stuff that we've seen in the middle east and for as long as I can remember and then being such a major producer of Crude Oil worldwide.

Obviously when tensions heat up, the price of Crude Oil goes up. You want to see if there's going to be a war in the middle east, look at the price of crude. If it's going up hard, tensions are rising. If you're looking at the spreads on that, you would buy a near term going into war and sell a deferred contract because we're worried about interruptions within supply. What if tankers can't get out of the Persian Gulf? We're going to stop production, you know, stop supply going to the refineries. They're going to be short, they don't have 6 months of storage sitting in a tank that they can refine and turn into gasoline and heating oil and we can heat our houses and drive our cars. They've got a week, maybe. I'm not even sure if they have a full week, so an interruption within that process can really move the spreads. It will really move the underlying price of crude oil, as well.

If you think that there's going to be peace, you know the old trader saying is "Buy the room or sell the cannon fire." Or "Buy the room or sell the fact." Going into war, we worry about production stopping totally, but once we get into war, you know, we realize okay, they're still going to get production out and a lot of other places do have crude oil besides the middle east. We still may have a supply, so looking at that, then you would look at buying a deferred and selling a front month. Typically in the crude oil market, you want to look at, when you're trading it, you want to look at a- buy a front month, you want to tend to look at a contract that's going to expire in maybe 2 or 3 months. Because really, kind of like the February contract expires in the middle of January. It's not like a lot of the other commodities where a February contract expires in February. In the Crude Oil market, a February contract expires in the middle of January. So, you're kind of losing that last half of the month. Then, you have delivery in there, so you're trading from a speculators standpoint, you know, in November and December you're trading February contracts.

Lan: I want to make a point here, I mean, this is an obvious- I mean it seems obvious to us, but sometimes an obvious question needs to be asked, a spread, you can only trade a spread of a market that overlaps each other. You can't trade too far apart from each other, because the contracts don't overlap and the prices don't have a spread between them.

Scott: Right, and the other thing that you have to worry about is the further out you get, the less volume and open interest there is. That creates a wider bid offer spread. It's what we call liquidity. The wider that bid offer spread is, the more risk there is in there. It's like when you go to sell your home, most people don't sell their home. Example: I decide I'm going to sell my home, and it's 11:35 in the morning; gee by 12:00, I can sell my home. No! I have to list it with the real estate agent and they're going to put the word out. Then, people are going to come look at it, you know, if it's a real hot real estate market I might be able to sell it in a week. If it's like real estate markets in most of the United States the home is going to be on the market for 3 months. A lack of liquidity. The back months have lack of liquidity. You see that whole within an illiquid market, of you know, gee I want $250,000.00 and the bidders are coming in at $235,000.00. Maybe we'll meet in the middle or maybe he comes in and he says $235,000.00 for your house and I say no, and that's that. He won't step up and pay my $250,000.00. You have that same thing in illiquid futures contract, then that adds to the spread.

Lan: I think it's important that you look at the underlying futures, that you are going to spread. If you're going to place a spread on a futures order you need to pull up the underlying futures. Of course, Track 'n Trade gives you that capability, you can pull up the underlying futures market. You can look at the date and see the liquidity of each market. Then, you can see how long they're going to be overlapping and how long that spread is going to be and where you tend to get in and where you intend to get out.

This is part of your business plan and you need to be aware of which market you're buying and selling and how liquid they are. Because it's going to show the success of, or be the major part of success of your spread trade.

Scott: Yeah, and whether you're spreading or not, you have to do that. There is no reason if it's the middle of July for you to be trading a September of the following year or a red September Oat contract. It has an open interest of 6 contracts. When you want to go to sell, you know you might look at a last sale of 160, but the bid on it is 150. You're giving up 10 cents. That might be your entire profit, just to get out. It's kind of what we used to refer to on the floor as a "roach motel." It's really easy to get in, you just can't get out. Whether you're a straight futures trader or a spread trader and it is even more important than the spreads, you would have to look to trade the liquidity.

Lan: They're a little bit more complicated because you're making what seems to be one trade, but you're doing it on 2 contracts. Therefore, you're doubling your effort in and your research. You have to make sure both contracts that you're going to place this spread on are liquid and contracts that are going to overlap for long enough period of time that you have enough time to actually realize a profit.

Scott: Exactly, and you're looking at a market that's going to move less. So, that added expense of the lack of liquidity reduced your already reduced profit potential. Then, you're looking at a higher cost to trade a commission, you know, it all adds up. Definitely do your homework. But I think you'll find, and you'll see why the popularity of the delivery spreads of the intramarket spreads is this wonderful trending nature we've seen. The kind of just general- they're very tradeable and they're very tradeable from a longer term standpoint.

If you tend to be more of a longer term trader, this is definitely something that you can look at. Another major advantage is the huge margin breaks you get on most of these and that allows the smaller capitalized trader to take less risk- and put less of his or her account at risk at any one time. For more diversification within that. That gives you a better chance of long term survivability. That basically covers the delivery spreads and or the intra-market spreads. I really encourage people to go back and look at the history of the spreads they're considering. Decide which times of year do these contracts tend to be liquid and then concentrate on those and then look at the normal behavior of that spread.

You've been listening to Scott Barry and Lan Turner on intramarket spreads. Thanks for watching!


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