Finding Trades: Spreads

Spread trading offers some of the most dependable opportunities in trading and is one of the best ways for traders to get started with a small account. Finding good trades, however, can be a daunting task. For a sample of twenty commodities, there are hundreds of intra-commodity spreads and over ten thousand inter-commodity spreads. This article presents a technique that can be used to help in the process of sifting through these many possible spreads to find the most profitable trades.

To demonstrate the technique, consider the fictitious seasonal chart below for the January contracts of commodity X (figure 1).

Figure1

What would the seasonal chart look like for the March contracts of commodity X if those contracts had the exact seasonal tendencies of the January contracts? It would be the same as figure 1 except that the curve would be shifted as shown in figure 2.

Figure 2

Notice that the vertical distance between the two curves remains constant in time. This only occurs because of the assumption that the different months have identical seasonal patterns. As long as this vertical distance remains constant, a spread of these two contracts will, on average, remain constant. So, there’s no profit opportunity.

In order to find a profit opportunity, one should look for contracts that have different seasonal patterns. One method for doing this is by looking for divergences between the seasonals. For example, consider the seasonal chart for the January and May contracts of commodity Y in figure 3.

Figure 3

In this example, the divergence between the seasonals for the January and May contracts can clearly be seen. Beginning in August, the seasonal for the May contracts begins decreasing while the seasonal for the January contracts continues to increase. This alerts us to the possibility of profiting from a spread formed by going long the January contract and short the May contract. The position should be initiated at the beginning of the divergence and closed when either the divergence ends or one of the contracts gets too close to expiration.

Now, let’s apply this technique on some real data. Consider the seasonals for the April and October contracts of Live Cattle shown in figure 4 (generated by the Multiple-Month Seasonal program).

Figure 4

The figure shows the seasonal for the October contracts gaining on the seasonal for the April contracts starting at the beginning of the October seasonal and continuing until around March 3.

The profit/loss for this trade can now be determined using Spread Calculator program.

We see that there was only one losing trade out of the last ten years. The average profit was $1,184.00 per trade and the maximum adverse excursion averaged $711.00 with a maximum of $1,830.00.

Have all the divergences between the seasonals for the April and October contracts been found? They have not. The previous seasonal chart (figure 4) gives no information about spread opportunities during the period from May through October because of the way the seasonals were superimposed. To see all the opportunities, it is necessary to plot two cycles of each seasonal as shown in the figure below. Again, the Multiple-Month Seasonal program is used with the "cycles" selector set to 2 rather than 1.

Here we see the spread (of the average seasonals) go from about zero where it says "open" to over 4 cents/lb when the October contract ends.