 To Spread or not to Spread
Kevin Kerr
The Daily
Reckoning
Apr 2, 2007
The Daily Reckoning PRESENTS: Next to options trading, spread trading
confuses more new traders than any other type of trading order.
Luckily, our resident commodities guru, Kevin Kerr, is here to
explain. Read on...
It's actually quite simple
if you don't let all the jargon make you nervous. Basically,
what you're doing is taking a simultaneous long and short position
in an attempt to profit. The profit comes from the differential,
or "spread," between two prices. A spread can be established
between different months of the same commodity (called an interdelivery
spread), between the same or related commodities, usually for
the same month (intercommodity spread), or between the same or
related commodities traded on two different exchanges (intermarket
spread).
You can enter a spread order
at the market or you can designate that you want to be filled
when the price difference between the commodities reaches a certain
point (or premium). Take this spread example: We want to buy
1 June Live Cattle and Sell 1 August Live cattle when the August
cattle contract is 100 points higher than the June contract.
The order would read something like this:
BUY 1 JUNE LIVE CATTLE, SELL
1 AUGUST
LIVE CATTLE PLUS 100 TO THE AUGUST SELL SIDE.
Sounds confusing but it's not,
trust me. Again, all this means is that you want to initiate
or liquidate the spread when the August cattle contract price
is 100 points higher than the June cattle. These days, most exchanges
don't report spread transactions on their quote boards, but a
few do. The best way is to find out from your broker who will
call the trading floor or the order desk and ask them to get
a "fresh quote." Another way to figure out where a
spread may be is to take the two prices and simply add or subtract
one from the other. Always confirm this with your broker or the
trading floor before entering any spread trade.
Just like everything in commodities,
after you get used to the basics of spreads you'll become aware
of more complex strategies that include but are not limited to
things like: Condor spreads, Crack spreads, Crush spreads--the
list goes on ad infinitum. No, a condor isn't some exotic bird
of prey, it's just trading-ese for a rather exotic spread trade.
Condor spreads are sometimes referred to as "elongated butterflies."
That helps a lot, right? Let's try another approach.
Take a long call condor spread.
This bird consists of a long call of a lower strike, one short
call of a second strike, one short call of a third strike and,
finally, a long call of a fourth strike. The calls have the same
expiration, and the strikes are equal distance apart. Now you're
probably scratching your head saying..."When would I ever
use this?" Exactly! A condor spread is such a specialized
strategy that it's hard to say what the individual's reasoning
would be for using it; it would be different on a case-by-case
basis.
I will say that spread trading
- even complicated spreads like condors - can have value for
some investors. Now I'm in no way advocating this type of trading,
even for the seasoned options trader like myself. The biggest
and most glaring problem with these complex spreads are that
the only person that usually makes money is your broker. Condor
spreads, like butterfly spreads, involve significant transaction
costs which make them prohibitive for option traders who do not
qualify for major commission discounts. The cost of this position
must be examined carefully before establishing it.
The best thing to do is avoid
trading any of these complex option strategies altogether. The
risks of these option spreads far outweigh the advantages, and
sometimes are far more hassle then they could ever be worth.
Some other types of spreads
are more mainstream and do offer good opportunity. Two of those
involve a main commodity that has products created or derived
from it. A crush spread, for example, is simply a spread between
soybeans and soybean meal and or soybean oil, sometimes called
"putting on the crush." A crack spread has nothing
to do with illegal drugs; it's the same type of spread as the
crush, only involving crude oil and unleaded gasoline and /or
heating oil.
Let me interrupt myself for
a second--I know all of this lingo can sound like mumbo jumbo,
but rest assured that as you need to know these things you will.
I myself, when I was first introduced to the markets, felt completely
lost. I was utterly bombarded with a whole spectrum of new expressions
and terms my first few weeks on the trading floor. While the
old saying "fake it till you make it" worked for me,
I suggest instead finding a broker or trading mentor, much like
my readers have found in me. Use this person, ask questions,
solicit advice, and whenever you're not sure of what the terminology
means, ask.
In my experience, people usually
like nothing better than to talk about themselves; they like
to teach someone something they know. So never hesitate to ask
the questions; after all, it's the only way you'll learn.
Spreads can be very valuable and profitable but it's important
to start with the basics and then move on to the more exotic
stuff when and if appropriate. Whenever I have an important decision
to make I make two lists, Pro vs. Con. Here are some basic pros
and cons of spread trading:
Pros
- Spreads in commodity futures
offer lower margin rates because these strategies usually carry
less risk. (We'll talk more about margins in a minute.)
a
- Spreads are usually less volatile
and prices move less quickly, which can be good for beginners
who may be intimidated by the speed and price fluctuations of
a single outright trade in the futures market.
a
- Spreads offer unique hedging
opportunities in a variety of commodities.
a
- Certain types of spread trading
allow the trader to pay less in margin, funding the purchased
future or option with the sale of the other side of the spread,
thus reducing initial costs.
Cons
- Spread trading has much higher
transaction (commission) costs because you're using more than
one trading vehicle. That's why it's even more important for
a spread trader to have an excellent entry and exit point, because
every penny will count.
a
- Spreads are often not traded
"outright"; in other words on their own in some commodities,
so you must "leg" into them which can be tricky for
the novice. (More about outrights vs. legging into trades in
the section on "Locals," later on.)
a
- Spreads can be less liquid
than other trades, which could prove to be disastrous if you're
trying to get out of a position in a hurry.
a
- Spreads have limited profit
potential most of the time. For example, if a trader buys July
corn and sells December and the July rallies but the December
contract doesn't really fall by much, and in fact rallies too,
then the trader's profits would be limited and the extra commissions
would cut into what little profit the trader made.
a
- Spread trading can be confusing,
especially to the newer trader.
My final word on spread trading:
It can be effective, but before entering into any spread trade
figure out if you really have a reason to be using this type
of trade, what purpose does it serve? If the answer is clear
to you then go right ahead. Remember the most important thing
to watch with spreads are those pesky transaction costs - they
can really add up, fast.
Regards,
Kevin Kerr
for The Daily Reckoning
email: dr@dailyreckoning.com
Kevin Kerr is the editor of
two highly successful and acclaimed financial advisory newsletters,
Resource Trader Alert and Outstanding Investments. A veteran
commodities trader, Kevin uses his irreplaceable experience to
advise his readers on a variety of commodities investments on
a daily basis. Widely considered one of the nation's top commodities
gurus, Kevin's expert opinions are routinely featured in the
country's premier media outlets.
The above was taken from Kevin's
soon-to-be-released book, A
Maniac Commodity Trader's Guide to Making a Fortune. In the
book, Kevin dispels the common myths and misconceptions about
these markets, offering an insider's view of what he calls "the
last bastion of pure capitalism on Earth." Whether you're
a novice or an experienced trader, Kevin's down-to-earth, clear-cut
guidance will make you more savvy, more confident, and more able
to jump right in and grab those profit opportunities that are
waiting for you. The book is available for pre-sale here.
321gold Ltd
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