Track 'n Trade Futures End of Day Spreads
Pros and Cons
Lan: In this example, Scott and I are going to discuss some of the pros and cons of trading Spreads. Why you would want to trade a spread. Why you would want to be involved in this market. Spread trading is like any other form of speculation, it's not for everybody. Trading spreads is very different than the short term hit and run trading that most of us outright Futures traders do. This section, we want to highlight some of the benefits and maybe some of the drawbacks of trading Spreads.
Scott: Lan, I would say most of the general reason why most people are attracted to Spreads are they tend to exhibit lower risk. They have extremely attractive margin rates, and the last one is kind of questionable but a lot of professional spread traders say they're more predictable than the outright markets. I can definitely say that the risk is lower.
Scott: Let's look at one of our favorite markets between both of us is Soybean market.
Lan: Okay, we're looking at November Soybean contract right here. It's the 2001 contract. What we're seeing is a nice little topping formation, maybe a 123 top, or something along those lines.
Scott: Exactly, and you know, this is the time of year when you expected as well, seasonally, you know, crop has been made, we should see some type of future production coming in. I agree, that sure looks like a 123 top, to me.
Lan: That's a little odd, it may be over here, it may be over there, anyway, what we're looking for is basically a risk off the top that we want to compare in this market vs. a Spread market, right? Exactly, look at the difference between the 2 and the (let's just say) the 2 and the 3 point there.
Lan: From a dollar stand-point, that's about $2,000.00 wide.
Scott: Yeah, you're going to risk .40 there, $2,000.00. That's a big risk.
Lan: That is a big risk.
Scott: Especially, in that most futures traders, in the $5,000.00 to $10,000.00 initial account range, risking $2,000.00 is anywhere from 20% up to close to 50% of their account. You don't have much room to be wrong when you use that type of leverage. But a way to maybe diversify and lower your bet size, and lower your risk, would be to look at a Spread.
Lan: Okay, let's look at the Spreads side. This is our Soybean November 2001 Soybean May 2002 Spread, Buy 1/Sell 1.
Scott: This is a new crop to new crop spread. They both represent beans, post harvest. November is typically our first real harvest bean contract. We don't have differential between harvest years. Again, we see a similar pattern in this spread to what we saw in the outright Futures.
Lan: We'll go back to the outright commodity, we can see what we're looking at here. We're looking at the same basic downtrend, right?
Lan: So, we want to look at the topping pattern that we see over here. This is a little bit different topping pattern, but across the top, maybe here, the spread risk would be about $300.00.
Scott: Exactly, vs. $2,000.00. What percentage is $300.00, going into, you know, $5,000.00 account?
Lan: Of course, if our risk is lower, obviously, our profit is going to be lower, as well. If we go down, and we're the smartest trader that there is, and we hit the bottom of that trend, when we get out we're making a $637.00 profit, where-as if we drop over to the commodity..
Scott: Right, we did an outright commodity straight off, we're going to be making closer to $3,000.00. You'll notice that the ratios, you know, risking $2,000.00 to make $3,000.00. Take a look at the spread, you know, we're risking $300.00 to make $600.00, or $350.00 to make $600.00. You know, it's similar risk to reward profiles between the two of them. It's just the dollar amount is much smaller in the spread. You also need to take a look at a margin rate. Margin is a definite..
Lan: You have a margin sheet, we can look at margins right here.
Scott: Yeah, margin is a definite judge of riskiness.
Lan: This margin sheet, we got this from the CBOT. This came right off of their website.
Scott: Right, and these are exchange minimum margins.
Lan: Which, of course, can be changed by your broker. Brokers can change the margins.
Scott: They're also subject to change by the exchange at anytime without notice. Which, the CFTC always tells us we should say that, whenever we mention margins, so we did.
Lan: Of course, I need to throw into Track 'n Trade Software, this comes set with the margins at the time that you receive the software. Of course, margins change all the time, so we give you the ability to change those margins. To update them, and keep them reflected to what your brokerage firm says they should be.
Scott: If we go ahead and we look at this, you know, we can take a look and say the initial margin for Soybeans is $810.00, right there. So, it costs- you have to have $810.00 in your account to trade 1 contract of Soybeans.
Lan: Your maintenance margin is over here, of $600.00.
Scott: Right. Now, look down at the spread margins for Soybeans. The initial margin is $338.00 with a maintenance of $250.00. It definitely shows you how much the exchange is. Your brokerage look at margin as a level of risk. They say, you know, you have to have keep that $600.00 maintenance in there, so you can always make good on that contract we just went into. The risk is $600.00, theoretically. That's a safety cushion that they need. On the Spread, they say because it's partially hedged, we'll need to keep $250.00. Somebody who, you know, you can either use spreads to be less aggressive, or you can do 2 or 3 spreads to 1 Futures contract. That's not uncommon, either.
Lan: You'll notice that when people do Spreads, they have a tendency to do larger contract quantities.
Scott: Exactly, it's not uncommon. For example: in the Soybean market down on the floor, let's just say it's 521.00 bid 521.50 offer. They'll put a size on that. Say 20 to 50 contracts. When I say 21 bid, I'm bid for 50 contracts. I'm good for it. It's 21.5 off or I'll sell you 50, I don't care which. You get into a Spread market and that market can easily be 300.00 up. Because margin requirements are less, they move less. A lot of professionals and commercials play Spreads.
Lan: Well, you mentioned earlier that there's the increased predictability of making it a little bit more likely that you're going to make your profits that you're looking for. So, increasing your quantity of contracts is a little bit more likely, as well.
Scott: Exactly, if you think about some of the popular Spreads out there, and we'll take one I know you're intimately familiar with, Lan, from background. Heating Oil, Unleaded Gasoline Spread. When is heating oil used?
Lan: Well, obviously, that's what we heat our homes with. So, it's during the winter months. Largest consumer of heating oil is of course, the US.
Scott: Exactly, and we use less unleaded gasoline then, don't we? People don't like to drive in poor weather. Especially in Utah, coming from Oregon, I don't see how you survive the winters!
Lan: You come into the spring time, and that's when the Unleaded fuel starts to move.
Scott: Exactly! So, though, the general trend of we're not sure whether heating oil prices are going to go up or down. We're pretty sure that most years Heating Oil is going to gain in value relative to Unleaded. Going into the winter heating season. While Unleaded would gain in value, relative to Heating Oil, going into the summer driving season in most years. Nothing is certain, but you can understand that general process of, 'we're not sure that prices are going to go up, but one may gain relative to the other.' It makes sense in the standpoint of, you know, if they're both over-produced you're probably more likely to see a shortage or a jump in demand for heating oil, going into the heating season than you will at the tail end of the summer driving season for Unleaded. Vise Versa in the spring.
Lan: So, this is why, because you've got these different kinds of strategies that play off of each other, why Spreads are considered to be a little bit more predictable.
Scott: Right, I think another thing that's kind of interesting is to tie it back into the liquidity issue, as well. Just for the fact that we've all heard the term gunning for stops or whatever we want to call it. You don't see those games going on as much in the Spread markets strictly because you don't tend to see it's more off the beaten path.
Lan: They're not nearly as Spreads aren't nearly as sensitive to the sudden shocks of the markets, as well. If you see a gap up in 1 contract, you're probably going to see a gap up in the other contract, as well. Which would- if you're using the underlying Futures contract, it would be quite devastating, obviously, if you're in the wrong direction of the market to a small trader. Gaps can jump in and take out a lot of traders. In the Spreads side of it both markets gap, it's not going to change the spread all that much.
Scott: Exactly, that sort of goes to me into that increase predictability, and that you're not as subject to the whipsawing and the shaking of the latest weather or news, or how many times Alan Greenspan said "Inflation" during a speech.
Lan: Of course, you know, back to the more predictability, as more and more systems are created for trading commodities, you start seeing a lot of this system trader type of stuff. As they become more and more popular, some of those more and more popular trading programs effect, or can effect individual markets to some degree. People start predicting, they start using systems, because of the predictability of the systems that are being used.
Scott: You can't under-estimate that, even beyond you and I. We see all the advertisements or systems; a lot of the funds are run that way.
Lan: And they're the big traders. They're the ones that are moving big markets.
Scott: RIght, these are the guys that are coming in with 100 lots and 1,000 lots. They tend to be trend followers, they have entire staff devoted to finding things that work. They're going to look in the straight futures market, more than they're looking in the Spread markets. You're kind of getting off the beaten path. It's easier to find Gold where people haven't looked, than where it's been picked over for 100 years.
Lan: We've talked a little bit about the pros of trading Spreads, now let's talk about the cons of trading Spreads, because there are some. We don't want to decorate them up like a Christmas tree, because there are some cons to trading Spreads and why people wouldn't do it.
Scott: I was going to say in some of our talks before we started recording. Lan saying right along the lines and it's the number 1 complaint I've always heard about trading Spreads is "Boy they move slow!"
Lan: A lot of the reason why we're in this commodities market is because stocks move too slowly for us. I've always said commodities are a lot of fun to trade, because they're like Stocks on steroids. When we get into the commodities industry and we drop back down and say okay, let's slow ourselves back down again. Like what you said, it's like watching grass grow. It's a much slower process.
Scott: Also, your time frames. It took me, in my own trading, awhile to get use to holding things. I used to trade down on the floor where a long term position was, yeah, I held it for 30 minutes. That's a big position to trade!
Lan: Haha! Yeah! Well, and then in the futures market most of us hold it for, well, if we hold it for a couple of months, we're- that's a pretty good hold for us.
Scott: Yeah, you're huge! A couple of weeks is more typical of that's what you consider a position trader, or most people do. It is not uncommon to 6, 8, 10 weeks, hold a Spread position.
Lan: Right, because you have to hold it a little bit longer, because it moves slower, and there's not as much profit in the shorter periods of times, you have to hold it longer to make the money that you're looking for.
Scott: Exactly, and if you're not geared to do that, you're shooting yourself in the foot. You have to go with where your own strengths are.
Lan: One of the biggest problems with trading Spreads is the commissions.
Scott: Yeah, you know I've heard it said that brokers invented Spreads, so they can charge us twice.
Lan: Because they do, we charge- the situation is that we get charged because we're buying one, we're selling the other, we pay a commission to buy one and sell the other. They don't give you a break because you're doing a Spread on your commissions.
Scott: Yeah, they don't look at, oh, well, one Spread is really one transaction- we'll only charge you one commission. It involves buying and selling, and a brokerages fix cost that they pay their clearing firm, they pay the floor broker the whole 9 yards. It's based on 2 contracts. They pass that along like most any other business would.
When you're running a business, you know, it's kind of a double whammy here, as well. You're looking at smaller potential rewards out of Spreads, because it's less risk. Risk and reward in my mind, always go together. You're looking at smaller potential reward, with less risk, but you're looking at higher cost of doing business to get that smaller potential reward.
Lan: So, if you're going to put on more trades, you're going to be paying higher commissions, to achieve the higher rates of return.
Scott: Exactly, or you're swinging for a $600.00 trade, and you're paying $60.00 in commissions. Why, if you were trading an outright Futures contract, you might be swinging for a $1,200.00 trade, and you're paying $30.00 in commissions; or something along those lines, just to throw numbers out.
Lan: But you're risks are increased.
Scott: Now, here's something I would encourage most people to do, and it's the problem with Spreads- they can be a little complicated.
Lan: Yeah, you need to- they took a little bit more time for me to understand the concept when I first started looking at Spreads, to try to figure out the differences, and why we're even looking at a Spread in the first place.
Scott: Yeah, it took me a long time, as well, in fact, I'm still learning a few markets that I know very well. There are a lot that I don't understand. It is something that people tend to specialize in. I know the general rules of thumb, but it requires a little more education; which the education is harder to get in the Spread market. There's very little literature out there written on Spreads.
Lan: Yeah, we looked at looked ourselves, in an attempt to pull together information for this educational cd rom and seminar. It's scarce.
Scott: Yeah, you know, I can't name more than about 3 books on the subject. When you look at technical analysis or introductions to Futures, take your pick, you know. There's 3 dozen, easy, I'm probably missing a 0 on that number.
Lan: When it comes to Spreads, it's difficult to find good information.
Scott: So, they're a little more complicated, as well.
Lan: You're going to have to do a little bit of self taught, or self teaching, as well, and experiment and learn some things yourself. That's the great thing about this software, and this plug-in, that you can go in and you know- I didn't want to attempt Spreads until I had this module, and the ability to go through and actually see on the screen, what the thing does, and actually do some simulated trading. Place the orders and watch it make a profit. Then, you know, sit here and talk to you and learn about- well, I'm not so much concerned so much about what the underlying price of the commodity, but more more-so the difference in price between the two. That's a big eye opener. It's like, I really want to know the difference between those two, more-so than, are they going up or down? I want to know is one going to go up more than the other, and why?
This becomes much more of a fundamental aspect to trading, much more than technical. We play with the technical side of it, but this is very intriguing for the fundamental trader, who looks for the underlying markets to move up and down. Not only why one will move up and down, but why November will move slower than December, for example.
Lan: That's not even a technical reason.
Scott: No, it's the longer term nature of them. Part of it is why it's more suited for that, is the longer time frame you go out, the more fundamental in my opinion, the trend is.
Lan: You know what, we're-
Scott: We're driven, and you know, the next three days is fear and greed.
Lan: Recently we did the- Scott and I worked together to create the Seasonals Seminar, which we did the Seasonals Plug-In. It gives us the Seasonal natures in the market, and I really think that the Seasonal information that we put on that Seminar that you provided for us, telling us the underlying fundamental reasons why markets move is really quite a key for trading Spreads.
Scott: Oh, wholeheartedly. It is because you're going out to- you're forced to go out to a longer time frame. Or you get the benefit of going out to a longer time frame, depending upon how you look at it. It is much more fundamental in nature. The longer trend is set by supply and demand, you have to understand it. You need to understand how it shifts throughout the year, or how it should shift.