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93 | Spread Price | High | | | Contract Size | Net PIL | Case 1: Longbdlies | 50.00 | 74.10 | $24.10 | | 38,000 | $9.158 | Short hogs | 43.48 | 5S.00 | (14.52) | | 30.000 | (4JS6) | Ratio | | 1.27 | | | | »4 02 | Case 2: Short bellies | .70 | 74.10 | (19.40) | | 38,000 | (»7,372) | Long hogs | 40.52 | 58.00 | 17.48 | | 30.000 | 5.244 | Ratio | 1.35 | 1.27 | | | | (»2.I28) |
High Average Range Mean Pork bellies Live hogs Ratio Spread 54.70 43.80 1.25 10.90 74.10 58.00 1.27 16.10 64.40 50.90 1.27 13.50 19.40 14.20 30% 28% In Case 1, the trade produces a profit while the relationship adjusts to normal; in Case 2, there is a loss even though the same adjustment occurs. Two factors cause this: the different contract sizes and the absolute price range. If the contract sizes were adjusted to equal units, which can be done by trading four bellies and five hog contracts, the results would be: | FIL per | Number or | Total | | Contract | Contracts | | Case I. Long bellies | $9.158 | | $36,632 | Short hogs | (4.3S6) | | 21.780 | Spread results | | | $14.852 | Case 2: Short bellies | ($7,372) | | ($29,488) | Long hogs | S,244 | | 26.220 | Spread results | | | ($3,266) |
This is slightly closer to the correct results but not yet right. Adjusting the number of contracts for volatility means attempting to equalize percentage moves per unit size. The range of 14.20 in hogs and 19.40 in bellies combined with their contract size gives: Range Contract Size Towl Rodb Bellies Hos 19.40 14.20 38.000 30.000 $737,200 $426,000 .5779:1 For convenience, the ratio will be taken as 1 : 2, which means trading two hog contracts for every one pork bellies contract. Then:
P/Lper Number of Contraa Contracts NetP/L Ca$e I: Long bellies $9,156 I $9,158 Short ho£s (4,356) 2 (8,712) Spread results $446 Case 2: Short Ullies ($7,372) I ($7,372) Long hogs 5,244 2 10,488 Spread iuhs $3,116 Using the relative volatility and contract size to produce a spread ratio gives the correct results. Metal Relationships Most metals markets showed extreme volatility in early 1980 as a result of the silver crisis. Table 13-3 gives the comparable futures price moves of the four major metals maricets and shows the spread ratios that should have been used. TABLE 13-3 Metals Volatility and Spread Ratios | /978 | Casfi PrKes ]980 | 1985 | Contraa Size | | ) | Ratio GoU | Gold iVo2) | | | | 100 oz | | 70,000 | | Platinum | | | | 50 m | | 12,500 | | Silver {$toz) | | 38.00 | 6.50 | 5.OO0W | 33.00 | I65.00Q | 2.36 | Copper ($/lb) | | 1.35 | | 25.000 Ib | | 16750 | |
Gold is seen to be much more volatile than either platinum or copper but less than silver. During this volatile period, a spread of five platinum to one gold, four copper to one gold, and two silver to five gold would have been necessarj. Unfortunately, this spread ratio represents an exceptionally volatile period. From the beginning of 1985 through June 1986, the monthly average spot gold price varied from $302 to $345 per ounce-silver prices ranged from $5. to $6.45 per ounce. This produces the following relationship: Contraa Ratio Contracts Range Size Total to Gold innad Gold $43/oz 100 oz $4.300 3 Silver $l.34/oz 5,000 oz $6.700 1.56 2 The ratio of three gold to two silver is normally most practical but is not safe enough when prices move above these levels. Volatile Spreads Trading a high-priced spread is always riskier than one where both legs are at normal levels for the following reasons: 1. If only one leg is at a high level, the profitability of the spread depends entirely on the profitable trading of the most volatile leg 2. If both legs are volatile, specific events may cause them to move independently, creating unprecedented spread levels. 3. Highly volatile spreads are usually in nearby months and may not adjust to normal before the expiration of the contract. At expiration, extreme demand in the cadi maricet may cause further unusual spread differences.
4. highly volatile spread may have greater rid; than a single outright position in one leg. This is not usually the pu ose of a spread trade. LEl-ERAGE IN SPREADS Because a spread is the difference between two or more fundamentally related marfcets or delivery months of the same marfcet, the risk is usually less than that of an outright long or short position. Interdelivery spreads within the same crop year, or in nonagricultural products, are recognized by the exchange as having lower risk. The result is thai spread margins can be less than 20° of the maiin required for a nonspread position. Because the m- on outright positions may be as low as 5" of the contract value (underlying asset), the spread marfcet can be as low as 2"-o. The profit potential is also less for a spread than for a net long or short position. You would expect that, if the margin requirement is 20° of the outright position, then both the ride and reward of the trade would be about 20° of an outright position. That is not necessarily the case. In agricultural products, the bull and bear spreads can be highly volatile; in contrad, the potential for an intramarfcet metals spread is equal to the change in interest caused by higher and lower contract values. Traders manage to compensate for the lower profits and rides by taking advantage of the smaller margins and entering more positions. With five contracts, the trader has managed to convert a conservative spread trade into the same risk and reward as a nonspread trade-perhaps with even higher ridc-without added cspital The small trader, however, should not leverage spreads to their maximum Some trades that derive the benefit of spread margins are not always of proportionately less ride. For example, when the IMNI began, any two currencies could be spread with reduced margin. A short position in the Deutschemarfc against a long position in the Mexican peso would hardly have been considered reduced ride when the first devaluation of the peso occurred. The trader must keep in mind that the decrease in margin, which accompanies spreads entered on the same exchange, will cause a substantial increase in leverage and may counteract the intrinsic risk reduction in a spread that was related to the smaller price movement. Spreads are not necessarily less speculative or safer than trading a single net long or short position.
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