Spread Trading
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You are correct - there's not much information out there about spread trading, but it is the dominant strategy used by prop firms, bank desks, and hedge fund desks. Quite the paradox. You won't find too many hedge fund or bank desk traders with a mouse in their hand scalping ES using a MACD and order flow delta software - but that's the type of scenario portrayed by literally thousands of trading books about what speculators should be doing. But nothing about a bank desk making markets in plain vanilla two year interest rate swaps and spreading them (hedge) against Eurodollar futures. Which is very odd to me.
Seasonality is but one of many fundamental variables that affect the forward curve structure in commodities. Speaking for myself - the indicator package and trading system that I have developed accounts for seasonality, supply vs. demand variables, mean reversion, etc. provided that those factors are reflected in the spread's price differential. In other words, I'm not going to take a bet on seasonality that isn't confirmed with price behavior. If a spread differential has been converging for ten months, I'm not going to take a bet on that price differential to diverge, or mean revert - until my indicator package confirms it with price action. This is critically important to me, because I want to have a very large portfolio of spreads to look at. I want really advantageous risk vs. reward. If I confine myself to one sector like US interest rates or European stock index spreads - I'm going to have to endure cycles of time where the trade set-ups just aren't as juicy as they could or should be.
Swing trading is smart for a couple of reasons: 1. the capital margin requirements for exchange recognized spreads are a fraction of the outright futures contract - there's not a cheaper way to trade futures that I'm personally aware of. So you should take advantage. If you've got a very good trading system and the margin on a spread is a few to several hundred dollars - why not hold it? 2. Why trade for a couple tics during the course of a day, when you can take, let's say, twenty or thirty tics out of a spread trade in a few weeks time? If you take three tics out of a spread trade that's fine, but remember that you are paying commissions and fees on multiple legs. If you take three hundred dollars out of a 1-2-1 Crude Oil Butterfly - the math is fantastic at retail commission rates but much less so if you take thirty dollars out of the same trade.
The best part about exchange recognized spread trades is that since you are trading the price differential between highly correlated products, the spread's true price action is almost always going to be much smoother and better behaved than the outright futures contract.
The downside to spreads is that you are paying commissions and fees for a position with multiple products or "legs". It's a problem if you are day trading for a tic or two, but it's not a problem at all if you are swing trading.
Between CME, ICE, Euronext, and Eurex there are literally tens of thousands of exchange recognized and supported spreads. These exchange spreads eliminate legging risk - you are trading a singular exchange price quote on the spread differential and the exchange uses an internal order matching algorithm in order to fill the order for you. This is a hugely positive development, because it wasn't that long ago that you had to manually 'leg' spreads or use execution software like "AutoSpreader" in order to complete the spread position.
Seasonality is but one of many fundamental variables that affect the forward curve structure in commodities. Speaking for myself - the indicator package and trading system that I have developed accounts for seasonality, supply vs. demand variables, mean reversion, etc. provided that those factors are reflected in the spread's price differential. In other words, I'm not going to take a bet on seasonality that isn't confirmed with price behavior. If a spread differential has been converging for ten months, I'm not going to take a bet on that price differential to diverge, or mean revert - until my indicator package confirms it with price action. This is critically important to me, because I want to have a very large portfolio of spreads to look at. I want really advantageous risk vs. reward. If I confine myself to one sector like US interest rates or European stock index spreads - I'm going to have to endure cycles of time where the trade set-ups just aren't as juicy as they could or should be.
Swing trading is smart for a couple of reasons: 1. the capital margin requirements for exchange recognized spreads are a fraction of the outright futures contract - there's not a cheaper way to trade futures that I'm personally aware of. So you should take advantage. If you've got a very good trading system and the margin on a spread is a few to several hundred dollars - why not hold it? 2. Why trade for a couple tics during the course of a day, when you can take, let's say, twenty or thirty tics out of a spread trade in a few weeks time? If you take three tics out of a spread trade that's fine, but remember that you are paying commissions and fees on multiple legs. If you take three hundred dollars out of a 1-2-1 Crude Oil Butterfly - the math is fantastic at retail commission rates but much less so if you take thirty dollars out of the same trade.
The best part about exchange recognized spread trades is that since you are trading the price differential between highly correlated products, the spread's true price action is almost always going to be much smoother and better behaved than the outright futures contract.
The downside to spreads is that you are paying commissions and fees for a position with multiple products or "legs". It's a problem if you are day trading for a tic or two, but it's not a problem at all if you are swing trading.
Between CME, ICE, Euronext, and Eurex there are literally tens of thousands of exchange recognized and supported spreads. These exchange spreads eliminate legging risk - you are trading a singular exchange price quote on the spread differential and the exchange uses an internal order matching algorithm in order to fill the order for you. This is a hugely positive development, because it wasn't that long ago that you had to manually 'leg' spreads or use execution software like "AutoSpreader" in order to complete the spread position.
I'll try to give you a little comparison of spreads. Two types of basic futures spreads
Intra-market, Time spread, Calendar Spread, Settlement Spreads, Delivery Spread, etc.
Financial Futures: Professional stuff ranging from highly levered rate differentials to really complicated market making involving SWAP and other OTC markets. Used in various forms of arbitrage/hedging related to complex banking operations.
Index Futures: Arbitraged against funding rates (LIBOR, etc) illiquid, no vol
Agricultural Futures: Low vol that can blow out, can trade the whole curve e.g. fly's, seasonal stuff is common, tons of jargon and very deep. (crop spreads, convenience yield, full carry)
Metals Futures: Don't know, probably specialized knowledge required.
Energy Futures: Extremely serious due to the size of the actors involved. Retail is at a major informational disadvantage. The pro's have insane amounts of money, tech, and resources. Complexity ranges from simple to totally professional. Varied.
Inter-market, Cross-Hedge, Correlation Trade,
Futures Baskets, Relative Value, and Relative Performance
Financial Futures: Used by rates traders to control risk and speculate (NoB, BoB). Many different types of trades are possible here. Huge amounts of speculation going on. This is one of the most influential markets of all!
Index Futures: Used to trade equities with very high leverage, and to hedge international equities risk. Huge opportunity for smart traders to spread global indices!
Agricultural Futures: Different ways to play vol and take speculative positions. So varied can't really offer you much, need to study it to learn anything.
Metals Futures: Speculate on metals ratios in the front month. Used to hedge other market risk.
Energy Futures: Traders use these as a way to increase or decrease volatility. Hugely speculative.
The types can be combined and even more complexity can be added in. Traders trade all of these and more (for good reason). Most people don't have the necessary training, experience, or knowledge to trade more than a small part of this stuff.
I started a discussion on ET about index spreads here.
https://www.elitetrader.com/et/threads/index-spread-traders.335197/
Good luck in your trading!
Intra-market, Time spread, Calendar Spread, Settlement Spreads, Delivery Spread, etc.
Financial Futures: Professional stuff ranging from highly levered rate differentials to really complicated market making involving SWAP and other OTC markets. Used in various forms of arbitrage/hedging related to complex banking operations.
Index Futures: Arbitraged against funding rates (LIBOR, etc) illiquid, no vol
Agricultural Futures: Low vol that can blow out, can trade the whole curve e.g. fly's, seasonal stuff is common, tons of jargon and very deep. (crop spreads, convenience yield, full carry)
Metals Futures: Don't know, probably specialized knowledge required.
Energy Futures: Extremely serious due to the size of the actors involved. Retail is at a major informational disadvantage. The pro's have insane amounts of money, tech, and resources. Complexity ranges from simple to totally professional. Varied.
Inter-market, Cross-Hedge, Correlation Trade,
Futures Baskets, Relative Value, and Relative Performance
Financial Futures: Used by rates traders to control risk and speculate (NoB, BoB). Many different types of trades are possible here. Huge amounts of speculation going on. This is one of the most influential markets of all!
Index Futures: Used to trade equities with very high leverage, and to hedge international equities risk. Huge opportunity for smart traders to spread global indices!
Agricultural Futures: Different ways to play vol and take speculative positions. So varied can't really offer you much, need to study it to learn anything.
Metals Futures: Speculate on metals ratios in the front month. Used to hedge other market risk.
Energy Futures: Traders use these as a way to increase or decrease volatility. Hugely speculative.
The types can be combined and even more complexity can be added in. Traders trade all of these and more (for good reason). Most people don't have the necessary training, experience, or knowledge to trade more than a small part of this stuff.
I started a discussion on ET about index spreads here.
https://www.elitetrader.com/et/threads/index-spread-traders.335197/
Good luck in your trading!
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There are, quite literally, tens of thousands of exchange recognized spread combinations at every futures exchange. And of course, there are esoteric inter market spread opportunities involving swaps, futures, options, cash, OTC physical, etc. etc.
This is quite literally a trading strategy that the majority of professionals use, and that retail speculators could use but they just don't know how. Spreads are so frequently used that trading exchanges have hedge ratio credit agreements between them. For example, if you have a spread between the Russell Index (ICE) and ES (CME) the exchanges will give you a substantial margin credit. I used to spread Nymex Clearport NG Swaps against ICE LCH Electricity all the time and got something like a 65% margin credit at the time as I recall.
I have spread traded Cash US Treasuries versus Treasury futures. I have spread OTC Natural Gas Options versus OTC term electricity options. I have spread metals, interest rates, coffee, sugar, cocoa, currencies of all manner, US and European hydrocarbons, ethanol... it's a big list.
For simplicity's sake - an example of an inter market spread might be to sell the Russell 2000 Index and to buy the S&P 500 Index as a hedged spread position. An example of an intra market spread might be to sell June ’20 Crude Oil and to buy September ’20 Crude Oil as a hedged spread position.
This is quite literally a trading strategy that the majority of professionals use, and that retail speculators could use but they just don't know how. Spreads are so frequently used that trading exchanges have hedge ratio credit agreements between them. For example, if you have a spread between the Russell Index (ICE) and ES (CME) the exchanges will give you a substantial margin credit. I used to spread Nymex Clearport NG Swaps against ICE LCH Electricity all the time and got something like a 65% margin credit at the time as I recall.
I have spread traded Cash US Treasuries versus Treasury futures. I have spread OTC Natural Gas Options versus OTC term electricity options. I have spread metals, interest rates, coffee, sugar, cocoa, currencies of all manner, US and European hydrocarbons, ethanol... it's a big list.
For simplicity's sake - an example of an inter market spread might be to sell the Russell 2000 Index and to buy the S&P 500 Index as a hedged spread position. An example of an intra market spread might be to sell June ’20 Crude Oil and to buy September ’20 Crude Oil as a hedged spread position.
Thank you @bone and @Real Money. I've done lots of research on the different types of spreads exchange traded, synthetic, intra, inter, etc... I even have access to a professional grade execution platform with an Autospreader. What I fail to understand is what strategy do most prop traders employ. I understand big commercial commodity traders are looking at fundamentals and it's very focused on a certain commodity. But what strategies are prop traders employing. What I'm looking for is a couple of examples of strategies they might use. Can you guys give an example of what a mean reversion play might look like for example?
@bone you mention price action above. Are you looking at support and resistance, consolidation on a chart. Are you looking at price action on the spread chart or the chart of the legs?
@bone you mention price action above. Are you looking at support and resistance, consolidation on a chart. Are you looking at price action on the spread chart or the chart of the legs?
Sure. Check this out. MARKET CAP SPREAD EXAMPLE (US EQUITIES INDICES)
Let's say your a prop trader and you want to trade equities.
Well, if you spread two of the indexes against each other (risk adjusting the exposures) then you can suppress the volatility of the trade significantly. CONTROLS THE RISK !!!
This will allow you to lever up, while still preventing a sudden catastrophic risk from news releases, market shocks, sudden moves in interest rates, and any other external event.
In other words, the traders trading the spread would actually have to cause you to start losing.
This risk profile is attracting A LOT of big traders at prop firms, and others, etc.
This example is a spread of the DOW (price weighted top 30 broad sector index) against the RUSSELL (market cap weighted top 2000 broad sector small cap index).
You can swing trade it using simple detrending and momentum.
Here I use a rolling linear regression average (red line), then detrend the spread against that (sub-chart).
Then I put fast (yellow) and slow (blue) regression averages on the spread value against the red line.
With something like $2mm you could lever this up like ~100 times LOL.
If you caught that run up in early November for like 4000 USD then you would be up nearly $400,000 with relatively controlled risk.
I'm not a prop trader but I'm sure I could find some interesting ways to employ a fuckton of money like $2mm.
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Hi all,
Please can I get some help in working out spread ratios and price ratios for when 2 markets have completely different tick values or pricing.
An example i'm currently struggling with...
Both markets have the same tick value and similar volatility. However one is priced around $50 and one is price at $0.684.
Normally I would think "ok same volatility and tick value so just trade 1:1" but if I just minus one from the other on a chart the second leg barely makes a difference to the chart because its such a tiny fraction. Its basically just a chart of Leg1
Hope that makes sense. @bone any suggestion please?
Thanks very much
Please can I get some help in working out spread ratios and price ratios for when 2 markets have completely different tick values or pricing.
An example i'm currently struggling with...
Both markets have the same tick value and similar volatility. However one is priced around $50 and one is price at $0.684.
Normally I would think "ok same volatility and tick value so just trade 1:1" but if I just minus one from the other on a chart the second leg barely makes a difference to the chart because its such a tiny fraction. Its basically just a chart of Leg1
Hope that makes sense. @bone any suggestion please?
Thanks very much
Quick and Dirty: take on-the-run 30 day trading range for each leg and then monetize each leg's value. For example, take the last 30 days of trading range for Silver, monetize it, do the same for Gold, then calculate your hedge ratio for Gold versus Silver accordingly.
You have to be very careful about inter market spreads - if the individual components are not highly correlated (>95% close-on-close) you will get smoked on cointegration. Even then - the disparate order flows between them can be a challenge. A great example of this is Gold vs. Franc where they trade in completely different sectors.
With INTRA market spreads (like Jun CL vs Sept CL vs Dec CL butterfly) none of this is a problem. It's no accident that the vast majority of my clients tend to focus on intra market exchange supported spread combinations that are a bit downstream in the forward curve
.
You have to be very careful about inter market spreads - if the individual components are not highly correlated (>95% close-on-close) you will get smoked on cointegration. Even then - the disparate order flows between them can be a challenge. A great example of this is Gold vs. Franc where they trade in completely different sectors.
With INTRA market spreads (like Jun CL vs Sept CL vs Dec CL butterfly) none of this is a problem. It's no accident that the vast majority of my clients tend to focus on intra market exchange supported spread combinations that are a bit downstream in the forward curve
.
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