TRADING

TRADING EDUCATORS
EDUCATORS
SPREAD TRADING

SPREADS
SPREADS

Introduction
Introduction
Few traders seem to know how to use
spreads in their trading, yet spread trading is
possibly the safest way to trade of any other
method we have encountered. A mature
trader will take spread trading into
consideration as at least one, if not the only,
method of trading in the futures markets.
This is a strong statement and requires
explanation.

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SPREADS
When the futures markets were first conceived,
apart from the fact that the exchanges created
them as a way to make money for themselves,
the stated purpose of the futures markets was
to provide a means for producers and users to
hedge against excessive fluctuations in price.

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Hedging is both the economic and social
justification for the futures markets, and in the
eyes of the law, and society, it is the ability to
insure stable prices that is the rationale which
separates futures trading from outright
gambling. A futures hedge is in fact, nothing
more than price insurance.

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SPREADS
Producers and users can buy most any kind of
insurance imaginable. They can insure against
weather disasters and natural disasters.
Insurance can be purchased for health,
accident, life, liability, crop failure, etc. But
there is nowhere that producers and users can
insure against price fluctuations, other than by
hedging in the futures markets.

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SPREADS
Every futures hedge is a spread, and every
futures spread is a hedge. When a spread is
placed in effect, the risk changes from that of
price fluctuation, to that of the differential
between the two sides of the spread. A spread
tracks the difference between the price of the
underlying and the futures or between two
futures contracts.

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SPREADS
Spreading takes much of the risk out of using
the futures markets. Because every spread is a
hedge, it serves both a social and economic
purpose. Even the US government encourages
the use of hedging, and conducts classes for
various producers to teach them about the
benefits of hedging. Spreading when used
properly takes away much of the gamble for
both user and producer.

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SPREADS
In general, society frowns upon gambling.
Nevertheless, there are many traders in the
futures market who do gamble they gamble,
perhaps without realizing thats what they are
doing. Anyone who trades in futures without
the full realization of what is going on, is in fact,
gambling. This is regardless of whether that
person is a speculator, a producer, or a user of
the underlying physical or financial item.

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It would seem then, that there are four
categories of traders involved in the futures
markets.
Producers
Users
Speculators
Gamblers

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SPREADS
We believe there is actually a fifth category of
traders. SPREADERS. Lets see why this can
be so.
Producers and users employ the futures markets
to exchange the risk of price for the risk in the
difference between cash prices and futures
prices. This risk is much smaller than the risk
associated with that of price fluctuations.

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SPREADS
The speculator is willing to accept the risk of price
fluctuation in return for the greater leverage that
comes with that risk in the hopes of earning a
greater profit. The true speculator makes his
trading decisions based on knowledge gathered
from information about the behavior of the
underlying, seasonality, historical and current
trends, chart analysis, fundamentals, the market
dynamics, and knowledge of those who trade it.

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SPREADS
The gambler makes his trading decisions on gut
feelings, hopes, dreams of getting rich quick, tips
from the broker, inside information from friends,
and from the improper understanding and use of
indicators, oscillators, moving averages, and
mechanical trading systems. In general, he is
looking for a way to shortcut having to truly learn
what is going on. Unfortunately, most people
who attempt to trade fall into this category.

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SPREADS
The spreader is a trader who positions himself
between the speculator and the hedger. Rather
than take the risk of excessive price fluctuation,
he assumes the risk in the difference between
two different trading months of the same futures,
or the difference between two related futures
contracts in different markets.

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SPREADS
For example, a spreader might take the risk of
the difference in price between March wheat and
July wheat, or the difference in price between
December Kansas City wheat and December
Chicago wheat. Obviously, the risk taken for the
difference in price among related contracts is far
less than the price risk taken in an outright
futures speculation. This is because related
futures will tend to move in the same direction.

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SPREADS
But there is more, much more accruing to the
benefit of the spread trader. The spread trader is
able to earn a much greater return relative to posted
margin than is available in any other form of futures
trading. This is because margins on intramarket
spread trades are about 1/4th to 1/5th of those for an
outright futures trade. Although every spread trade
requires two commissions, this slight disadvantage
is far outweighed by the lower margin requirements.

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SPREADS
To give you an idea of the margin differential, as
this is being written, the margin on an outright
soybean futures contract is $1,050. The margin on
a January-March soybean spread is only $250, or
23% of that required to trade an outright soybean
futures. Is this important? Yes it is! Why?
Because each point in the spread carries the same
value ($50) as each point in the outright futures
($50).

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SPREADS
That means on 5 point favorable move in soybeans
futures and a 5 point favorable move in the spread,
the trader would earn $250. However the difference
in return on margin is extraordinary:
Soybean futures - $250/$1050 = 23.8% return
Soybean spread - $250/$250 = 100% return
So whats the catch? There has to be a catch!

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SPREADS
Yes! There is a catch. Spreads seem to move
less dramatically than futures. It would seem that
it is easier to realize a 5 point move in outright
soybean futures than it is to realize a 5 point move
in a spread between two soybean contracts
essentially moving in the same overall direction.
But to think that way is to truly distort the picture.
That view does not speak the whole truth. Theres
more to it than meets the eye.

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SPREADS
Spreads tend to trend much more dramatically
than outright futures contracts. An examination of
a variety of spread trades taken at random will
more than convince anyone of the beautiful and
often steep trends that one can regularly find
among spreads. Spreads trend without the
interference and noise caused by computerized
trading, scalpers, and market movers.

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SPREADS
The nemesis of all trading by those not big
enough to be market movers is that of stop
running. While there is nothing negative per se
about stop running, this action by market movers
is what causes most traders to be taken out of a
move with an outright loss on the trade, or with a
substantial loss of actual or potential profits.

SPREADS
SPREADS
Intramarket spreads eliminate the problem of
stop running. You are long in one futures and
short in another. There is no way for the market
movers to run the stops. In that respect, spread
trading is a more pure form of trading. The lack
of stop running is not a guarantee that you will
win, but it does provide the trader a more level
playing field.

SPREADS
SPREADS
Spreads eliminate the problems associated with
lack of liquidity. The surest way to encounter
serious stop running and bizarre price
movements is to attempt to trade in thin
(illiquid) markets. However, other than problems
with getting filled, spread trading does not suffer
from a lack of liquidity, thereby creating many
more trading opportunities than does trading in
outright futures.

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SPREADS
Unfortunately, either by accident or design, the
whole truth of spread trading has been lost over
the years.
While it is true that an outright futures trade has
a better chance of making points than does a
spread between two contracts of the same
underlying, it is also true that an outright futures
trade has a better chance of losing those very
same points.

SPREADS
SPREADS
When you enter an outright futures trade, the pure
statistical chances of being correct on the
direction of the trade are one in two. Some say
one in three. Heres why. If you are long futures,
the only way you can make considerable profits is
if prices rise. If the prices fall, you lose money. If
prices go sideways, you could make a little or
lose a little. Over time, the sideways moves tend
to even out.

SPREADS
SPREADS
If you are short futures, the only way you
can make considerable profits is if prices
fall. If the prices rise, you lose money. If
prices go sideways, you could make a little
or lose a little. Over time, the sideways
moves tend to even out. In other words,
with outright futures trades, the only way
you really win is to be correct about which
way prices will move.

SPREADS
SPREADS
When you enter a spread trade, you are not
primarily concerned with the direction of prices.
Your primary concern is with the direction of
the spread, i.e., the difference in price between
the two sides of the spread. To see what we
mean, consider a long July soybean, short July
corn spread. As long as July beans rise faster
in price than July corn, you will earn a profit.

SPREADS
SPREADS
In that case, the situation is the same as with
the outright futures, the odds are one in two of
winning. But heres the part no one seems to
want to tell you about. If the price of beans
suddenly changes direction and falls, as long as
the July corn falls more steeply than July beans,
you will also win. If we assume that when they
both go sideways, those situations will even out,
then we have odds of winning being two out of
three times that we enter a spread.

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SPREADS
What we are saying here is that with
outright futures you must be right about the
direction of prices in order to win. But with
a spread, you can still win even if you were
wrong about the direction of prices. You
can win when you are wrong, as long as
you are not too wrong.

SPREADS
SPREADS
We need to look at other advantages of
trading spreads. One of those is seasonality.
Whereas seasonality in outright futures
trades has shown a dismal record in recent
years, seasonality in spread trading has
shown an exemplary record. Seasonality
works extremely well in spread trading. The
percent of wins against losses is outstanding.

SPREADS
SPREADS
Another great advantage seen in spread trading
is experienced when a market goes into
backwardation. When backwardation first
commences, it is almost certain that a spread
long the front month and short the next month
back will do well. Fortunately, this situation
favors entering the spread for as many as
several days after a market goes into
backwardation.

SPREADS
SPREADS
Backwardation greatly favors spreads over
outright futures trades. Why? Because for an
outright futures trade to be correct about
backwardation, prices must rise. But it is a
known fact that backwardation can occur when
prices are falling. Due to stronger demand in the
front month, price will fall less quickly than will
prices in the back month. Therefore, a spread
long the front month and short the back month
will profit even in a falling market.

SPREADS
SPREADS
We are not denying that when backwardation
occurs you can go short the weaker back month,
but then you can always go short when prices
are falling. In that case, you are losing the
advantages of the spread. You are taking
outright price risk in a month that is less liquid
than the front month.

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SPREADS
What about the situation where markets are
moving sideways? As long as one trading
month of the market is moving up more than
another month of the same market, a spread
can be profitable, whereas a trade in outright
futures has to suffer the whims of the market.
Theres more!

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SPREADS
In a sideways market, as long as one trading
month of the market is moving down more than
another month of the same market, a spread can
be profitable, whereas a trade in outright futures
has to suffer the whims of the market. In other
words, if one month of a market is absolutely
sideways in price movement, but the other
month is either moving up slightly or down
slightly, the spread trader can win.

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SPREADS
Apr hogs

During the time the spread line was

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SPREADS
It is not our intention to reproduce an entire
book here in this presentation. Trading
Spreads and Seasonals is the text book that
accompanies this presentation. We can,
however, give you a few basics of spread
trading so that you can understand the
remainder of the presentation and its
examples.

SPREADS
SPREADS
A spread tracks the difference in price
between two or more futures contracts. They
can be contracts for financial instruments,
currencies, stock indexes, or physical
commodities. There are two multiple contract
spreads that are traded. One is called the
Crack, and the other is the called the
Crush. Most traders are never involved in
either of these.

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SPREADS
When structuring a spread the contract you
want to be long is always expressed first
and the contract you want to be short is
expressed last. Therefore, a spread
between Swiss Francs and Euros is
expressed as SF-EC.

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SPREADS
A spread can begin with a negative value. For
instance, CCH-CCK for 2002, entered in
November of 2001 began at a spread
differential of 5. If a spread begins with a
negative value, you want it to become less
negative, or even move to where it has become
positive. If a spread begins with a positive
differential, you want to see it become more
positive. Therefore, as you chart a spread you
always want to see it moving up.

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SPREADS
Long March Cocoa, Short May Cocoa
CCH-CCK was entered at 5. It
reached a spread differential of +8
The spread became valued at $130
($10x13 points), the difference
between the two contracts.

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SPREADS
When ordering a spread always give the long
side first, followed by the short side. I want to
buy (# of contracts) March Cocoa and Sell (#
of contracts) May Cocoa on a spread
of(give the value of the differential)
At this point, your broker may require one
additional piece of information. Brokers differ
as to how they want to hear it:

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SPREADS
To be certain that he understands what you
want, the broker may want you to tell him
where the premium is, whether or not you
are collecting or paying for the spread, or
whether this is a debit or credit spread. You
may even encounter some delay in getting
your order processed because some brokers
have never handled a spread trade. Lets look
at the terms named above.

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SPREADS
Premium is simply which side of the spread
has the greater value. E.g. the CCH-CCK
spread. Obviously, CCK had the greater price
in dollars. That is why the spread had a
negative differential. You were subtracting a
larger price from a smaller price. Therefore
the premium was to the sell side. The
premium was to the May, depending on how
your broker wants to hear it.

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SPREADS
Since you were paying a lower price for March
than you were receiving by selling May, you will
be collecting for the spread. If March had the
higher price, you would be paying for the
spread. If you are collecting for the spread, you
will receive a credit in your account, the
difference in what you paid to buy March and
sell May. If it were the other way around, you
would receive a debit to your account.

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SPREADS
You will have to discuss with your broker, the
exact terminology that he wants to hear when
ordering a spread. Dont be surprised if the
first couple of times you give a spread order,
he has to go and ask someone what to do.
But after youve issued a couple of spread
orders, he should have it down pat and be
able to understand what it is you want to do.

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Heres the way we gave the order to our broker
in accordance with the way he wants to hear it:
Buy (NYBT) March Cocoa and Sell (NYBT) May
Cocoa on a spread of 3 to 5 points, premium to
the sell side.
We were filled at 5, and took profits at +7 and
also at +8. One last thing concerning this and
other spread trades. We always have a mental
stop loss in mind before we enter a trade.

SPREADS
SPREADS
Long March Cocoa, Short May Cocoa
CCH-CCK was entered at 5. It
reached a spread differential of +8
The spread became valued at $130
($10x13 points), the difference
between the two contracts.

SPREADS
SPREADS
In the case of CCH-CCK, our stop strategy was
to exit on any day following a spread Close of 8
or more negative. We are interested only in
where the spread Closes. Spreads can wander
all over the place during the trading day. If you
try to watch them intraday, you will drive yourself
crazy. Apart from trying to optimize your entry
and exit, please avoid baby-sitting your spread
trades during the day. In the long run it will
cause you to make some serious mistakes.

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SPREADS
Now, lets look at some spreads. These are all
spreads that were traded as given in Traders
Notebook our daily trading newsletter. Weve
already shown you the March-May Cocoa
spread. Next well show you a long Swiss
Frank, short Euro currency spread.

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SPREADS
Heres how instructions were given to our
readers: Buy (CME) December Swiss Franks
and Sell (CME) December Euros on a spread
of 2830 to 2831 premium to the sell side.
Suggested protection is to exit on any day
following a close of 2844 or more negative.
Objective is for the spread to narrow to a less
negative number. Objective is 2770. Basis is
fundamental. Premium is to the Euro (EC).
You will collect on the spread.

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Entry was at 2830. Partial profits were
taken at 2768 ($775).
Entry

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SPREADS
Heres a Natural Gas spread: Buy (NYM)
February Natural Gas and sell (NYM) January
Natural Gas on a spread of .020. Protective exit
is any day following a Close at or below -.010.
Objective is .100. Basis is seasonal. Premium
is to February. You are paying for the spread.

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SPREADS

Partial profits taken at .045

Note: One additional benefit to spread

Entry

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SPREADS
There are some additional things that you should
know about spreads. Spreads lend themselves
to correlation analysis. You can look to see if the
spread currently is tracking the same as it has
for the past 15 year, the past 5 years, all the way
down to correlation with last years spread
movements. At extreme high and low spread
values, the spreads are very often accurate
down to the penny.

SPREADS
SPREADS
You can reduce the volatility in an outright
futures trade by spreading the contract you are in
against another month of the same contract, or
even against a month of a related contract. Lets
assume that you are long February Lean Hogs at
a time when prices suddenly drop ahead of the
Hog Report. You dont want to get killed if hogs
are reported to be in great supply, so you enter a
spread by selling the back month of April.

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SPREADS
February
lean hog
prices

Hedge by
spreading
here
Unfavorable
hog report,
Feb. prices
head down.

Long from
here

One day loss on Feb.

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SPREADS
April lean
hog prices

Hedged by
spreading
here
One day gain on
short Apr. hogs,
Close to Close was
152 points ($608).
One day gain on
the spread from
Close to Close
netted $268 (608340=$268)

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SPREADS
Did you see what happened? Instead of
losing $340 in the long February contract,
by selling an April contract there was a gain
of $268 on the trade. Why? Because short
April hogs made $608 on the day the report
came out, i.e., one day after having entered
the spread. By spreading, we took some of
the volatility out of the trade, and made a
profit from our attempt.

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SPREADS
Will we always make a profit by spreading?
No! But had the trade gone the other way,
with February dropping $608 and April
dropping $340, we still would have mitigated
a loss. We would have reduced the loss
from $340 to $268, or you might say,
lessened it by $72. Theres something else
to notice about the spread.

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Feb hogs
Weve graphed the 2 months together. Notice
that for quite some time, the spread was
moving the wrong way.

Apr hogs

But at the end it suddenly shot up indicating

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SPREADS
Feb hogs
Notice that for most of the life of these 2
contracts, it would have been better to be
long Apr and short Feb
Apr hogs

Long Apr and short Feb would have caused the

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SPREADS
Apr hogs

During the time the spread line was

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SPREADS
Apr hogs

It was Apr hog prices that were

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Apr hogs

Can you imagine how hard it would

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Apr hogs

Yet the spread during that time made

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SPREADS
All this is very interesting, but Im a day trader.
What good are spreads to me??
I have news for you my friend, lots of day
traders trade spreads. In the stock market
people trade the spread between the QQQ
Index and Microsoft. You have to use a time
frame that will enable you to comfortably put on
both sides of the spread, but that is a minor
problem. Lets have a look at this spread.

Long MSFT, short QQQ on a 5 minute chart.

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SPREADS
Another intraday spread is done between DJIA
futures and Nasdaq e-mini futures, or any two of
the e-mini indices. Since, both sides of the
spread do not tick at the same dollar value, we
create an equitable spread by using multipliers
to make them dollar-equal. Just as with physical
commodities, you can go long with either one of
these indexes, depending on what you see
happening.

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SPREADS
One of the most exciting things to happen in the
world of futures trading are the new security
futures. These offer some of the easiest and
most profitable spread situations in all of trading
history. We are already doing them. We would
love to teach you this fantastic way to trade.
You can spread one stock futures against
another; one stock futures against an index; or
one index against another index. Wow!!

NQ*20-DJ*10

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SPREADS
We dont have time and space in this
presentation to go into other types of
spreads. But please note, there is a very
unusual crush spread known as the cattle
crush long May Corn and short August
Live Cattle. Obviously, this is a calendar
spread. There are ratio spreads, ratio
calendar spreads and equitable spreads as
well. Learn about them at the seminar.

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SPREADS
Are you convinced about spreads? Whether
or not you are, you should complete this
presentation by reading Trading Spreads
and Seasonals. It may be the most
important trading book you will ever read.
Many students who have found it difficult to
succeed in outright futures trading have
found their success in trading spreads.

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SPREADS
You may want to browse our website for additional trading
information. You may also want to further your education with
our Profitable Spread Trading seminar, a seminar with a money
back guarantee. Earn back the price of the seminar within six
months or your seminar fee is returned to you. For further
details on the guarantee, see the next slide. Questions or
comments, please direct to ross@rosstrading.com or call +512249-6930 (800-476-7796 US).
Wishing you the best that life has to offer:
The staff at Trading Educators

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