SpreadProfessor Clients - Thanks !

[bone]

I am sending out a recorded webinar to clients today entitled: "Meat on the Bone". This is a 75 minute discussion with several current trade set-up examples.

Quite occasionally, trade entry set-ups might present a bit of a quandary to the trader in terms resolving a conflict between reasonable stop-loss and profit target level placement versus what we model as "available" trading range from trade entry price to profit target price. In other words, from a risk/reward standpoint, is there enough Meat left on the Bone - or is it a more prudent course of action to take a pass and that particular trade idea and move on to other possibilities ? I talk about using on-the-run historical vol and trading ranges to help with that decision process.

Most trade set-up ideas we encounter are straightforward in terms of entry "go" or "no-go".

 

[bone]

As spread traders, we are modeling the relative convergence or divergence between two or more highly correlated instruments. That is where the buy or sell entry signals are generated.

That, at least in my opinion, is the big difference between trading outright flat price instruments and a spread trade.

 

[i960]

As spread traders, we are modeling the relative convergence or divergence between two or more highly correlated instruments. That is where the buy or sell entry signals are generated.

That, at least in my opinion, is the big difference between trading outright flat price instruments and a spread trade.

There's also the lesser discussed but pretty important distinction that spreads tend to cut out a good part of externalized/systemic risk that's present but not immediately relevant to the instruments being traded.

For instance, outright crude traders are exposed to other externals such as USD or it's correlated counterparts like the Euro. A strong move in either will sometimes bleed into the price of crude and potentially negatively affect an outright trader's trade when they weren't even planning for it. You could have a solid WTI long trade on, go make a sandwich in the other room, whilst unbeknownst to you Mario Draghi drops some random reference to future QE in what was assumed to be a minor TV interview causing EURUSD, WTI, and Brent to shit the bed and take your stops out with it.

Even the simplest of spreads like an F+0/F+1 calendar (which of course isn't necessarily the best way to trade these) would defend against some of this risk due to the fact that each one is inherently short the dollar to an extent:

+ CLU6/-USD
- CLV6/+USD
== CLU6-CLV6

Hence the effect of the dollar is greatly diminished when spread against each other. Take June NFP and the whole Brexit chaos for instance. Here we have DX (light blue), 6E (cyan), and CLQ6 (purple) jumping around like crack fiends on each major news release (try trading through these purely on outrights and tell me your stress levels are fine) along with the Q6:U6 spread on the lower pane during the same time period:

Caveats:

• An intraday chart is used to show the day to day volatility - in reality one would probably not be trading spreads on this timeframe.
• The dollar doesn't always affect the price of crude. But if one knew it absolutely was going to, would you rather be positioned in the outright or a spread? A spread obviously.
• A simple calendar spread utilizing the same front month as the currently trading outright is probably not the best trading vehicle due to it's front month exposure - but the point here is that even the "worst" spread to be in is a heck of a lot less worse than the outrights themselves.

 

[justrading]

There's also the lesser discussed but pretty important distinction that spreads tend to cut out a good part of externalized/systemic risk that's present but not immediately relevant to the instruments being traded.

For instance, outright crude traders are exposed to other externals such as USD or it's correlated counterparts like the Euro. A strong move in either will sometimes bleed into the price of crude and potentially negatively affect an outright trader's trade when they weren't even planning for it. You could have a solid WTI long trade on, go make a sandwich in the other room, whilst unbeknownst to you Mario Draghi drops some random reference to future QE in what was assumed to be a minor TV interview causing EURUSD, WTI, and Brent to shit the bed and take your stops out with it.

Even the simplest of spreads like an F+0/F+1 calendar (which of course isn't necessarily the best way to trade these) would defend against some of this risk due to the fact that each one is inherently short the dollar to an extent:

+ CLU6/-USD
- CLV6/+USD
== CLU6-CLV6

Hence the effect of the dollar is greatly diminished when spread against each other. Take June NFP and the whole Brexit chaos for instance. Here we have DX (light blue), 6E (cyan), and CLQ6 (purple) jumping around like crack fiends on each major news release (try trading through these purely on outrights and tell me your stress levels are fine) along with the Q6:U6 spread on the lower pane during the same time period:

View attachment 165541

Caveats:

• An intraday chart is used to show the day to day volatility - in reality one would probably not be trading spreads on this timeframe.
• The dollar doesn't always affect the price of crude. But if one knew it absolutely was going to, would you rather be positioned in the outright or a spread? A spread obviously.
• A simple calendar spread utilizing the same front month as the currently trading outright is probably not the best trading vehicle due to it's front month exposure - but the point here is that even the "worst" spread to be in is a heck of a lot less worse than the outrights themselves.

Everything has a price.

You pay for the comfort of a spread. When you trade outright directionality, you get rewarded for the risk of shitting your pants. I just closed an October NG vertical that reached peak value of about $1,100 against the outright peak of $3,500+. Yes, cost basis and risk were different, but the outright always had better profitability, and went deeper in the red initially.

Oh, and I'm not being snarky, but for colour blind folks like me, I couldn't identify cyan or purple if my life depended on it; I'd just say shoot me and get it over with. My ex used to wonder why I bought purple toothbrushes, until she couldn't stand it any more and asked me why I picked that colour. I told her blue is my favourite colour.

 

[bone]

If a trader does well and is consistent with outrights - then I would be the last person to criticize. There is no one correct way to successfully trade markets.

Possibly another way still to look at it would be to lever the "more behaved" trading product. No one could argue that there are a number of very wealthy independents trading size Eurodollar Spreads in Chicago. And other futures prop traders posting on ET have commented on the popularity of spread trading strategies at their firms. My premise is that traders who are looking for more consistency, or another revenue stream... Or are even thinking about giving up - they should seriously consider a spread trading strategy. In the bank and the prop and the HF community it is a very dominant strategy, but it seems like many traders outside the Chicago, NYC, and London trading communities don't seem to know much about it.

 

[i960]

Possibly another way still to look at it would be to lever the "more behaved" trading product.

Agree with Pete here. Half the battle is in trying to find things that simply behave appropriately such that putting a trade on doesn't entail taking on negative adverse risk - or what I like to call "toxic volatility." If one can create a derivative instrument that reduces said volatility to something more controllable with a higher degree of predictability and trendability then that's a better trade IMO.

 

[Trader13]

You've made a strong case for spread trading ... it has more predictable behavior as the spread is based on a relationship (versus flat price trading) ... and the spread has the benefit of neutralizing systemic risk and perhaps other risks depending on how it's constructed. Adding the benefit of margin relief for some spreads makes it even more attractive.

The great debate in my mind is taking it to the next level: trading spreads for divergence vs. convergence. Although they are often mentioned at the same time as variations of spread trading, these are very different.

 

[bone]

The great debate in my mind is taking it to the next level: trading spreads for divergence vs. convergence. Although they are often mentioned at the same time as variations of spread trading, these are very different.

Convergence vs Divergence is analogous to choosing which product(s) / expiries within your spread combination to buy or sell. That simple. How are each of those spread components behaving towards each other on a relative value basis ?

For example, (this is entirely a fictional example) let's say that Dec 16 Two Year Notes have consistently gotten stronger vs Dec 18 Eurodollars on a volatility adjusted basis for the past five months - you would call that a divergence. To have played that, you would have bought 2's and sold Z18 GE on a hedged basis. Let's say that next month you come to believe that 2's will weaken versus Z18 GE, or the prices on a hedged basis will converge. Likewise you would sell the 2's and buy the Z18 Eurodollars.

Spread construction and modeling is the critical issue. And you have thousands and thousands of potential combinations.

 

[bone]

Expect to play a modest commissions premium (like about 10 percent or so) over "normal" retail rates for the courtesy of holding a position overnight. It is understandable in the sense that the FCM back office has to mark and margin the position as compared to a day trader who opens and closes the same position during the course of the trading day and is flat by settlement.

But if you make $600 on a Corn butterfly that you carried for three weeks, paying $25 in commissions and fees on the trade is no biggee.

 

[bone]

Ernie Chan reiterated in his blog and his book what he thought was a very wise saying: "You're not going to backtest your way into being a trader".