Not enough is written about spreads, and over the course of this year I’m going to change all that. In the commodity space, spreads are the lifeblood of the floor community. Fundamentally, they are relative value trades. They also set up well for commodity traders, because as such, commodity traders are ready to go long as well as short.
Not so for the typical equity trader. Even the talk of an equity pairs trade takes 6 levels of approvals from your compliance department. [Then you have to call 45 friends to figure out that there is no rebate on a commodity short sale, but I digress…]
Besides giving you more ways to be right, and potentially lower margin requirements than outright directional trades, spreads can be used as leading indicators. Take for example, the relationship between Gold and Platinum. Gold is a precious metal (and an industrial metal) and most readers will associate it with jewelry, it is involved in many electronic devices. Here’s a look at the April 2010 COMEX Gold chart.
Platinum is used for jewelry too, but it is mostly an industrial metal in refining petroleum products and in catalytic converters. Here’s a look at its chart – the April 2010 NYMEX Platinum.
The idea being if the economy is expanding, platinum should outperform gold, relatively speaking. So if you thought inflation was at bay, you could have bought Platinum and sold Gold using the April 2010 contracts shown above. [Whatever you do to the platinum contract is what you do to the spread. In this case therefore, you would have bought the spread.]
Here is what the spread looks like through tonight’s settlement:
What you see here, is that platinum (as you expected) outperformed gold over this period of time, and especially in the last few weeks. Buying the spread in this case would have netted the trader approximately $2,600 per spread (Buy 1 Platinum/Sell 1 Gold) Here are the calculations:
You’ll see that you made all your money due to the Platinum position. You lost on Gold, but the gains on the Platinum more than covered the losses in Gold. Very rarely will you make on both legs, as they’re called. Sometimes in certain grain spreads, but don’t count on it with the PL/GC trade.
Don’t employ excessive leverage b/c you may be afforded lower initial margin on a trade like this. Take advantage of the long-term view here and let the economics evolve. Follow the trend of the spread. Here is a 15 year seasonal view of this spread, courtesy of Jerry Toepke at Moore Research (Used with Permission).
You buy a spread when you want it to widen, or increase in value. Can you come up with all the ways this spread can widen?
This particular spread shows what can happen when the EXPECTATION of the economy is/was favorable. You can use this spread as a leading indicator on INFLATION. Once the spread starts to narrow, or decrease in value, you reverse these positions and sell the spread. Even if this spread trade is not for you, watch its trendline b/c once it’s broken, it will indicate that the market’s perception and outlook on inflation is a worry. And that is information you can use across all your asset classes.
I will have a full course on spreads and seasonal trades for the Certificate Program called, appropriately, Spreads and Seasonals. This course is one of the Electives and will only be available for those who’ve taken the 4 Core Courses.