Bull and Bear Spreads

A spread can he a low-rid; substitute for an outright long- or short-trend position. In grains and foods, a bull maitet will result in prices of the nearby dehvery months rising faster than deferred months. A bull spread can be placed by entering a long position in the nearby and a short position in a deferred month. Both rid; and reward are reduced, the greater the time between months, the more volatile the spread (Figure 13-12). As in an outright position, once the upward price peaks, the spread must be reversed because the nearby dehvery will decline fader than the deferred. By selling the nearby and buying the deferred contract, a bear spread is established.

The analysis that identifies the time to enter a bull or bear spread can be a standard trend-following spproach based on the nearby contract only. Many traders beheve that the spread itself must also confirm the trend before a position is taken, therefore, a moderatespeed moving average may be spplied to the spread series. This would provide a signal based on the relative change in spread direction. A simple I -day change might be enough for the fast trader. An upward trend signal in the nearby delivery and a bear spread movement is a conflict that should be passed.

Legging In and Out of a Spread

When both contracts, or legs, of a spread are not entered or closed out at the same moment, trading risk is

increased. An unprotected leg of a spread is simply an outrigiit long or short position and must be managed carefiilly. Consider a bull spread in a festmoving marfcet. Although both legs can be entered simultaneously using a spread order, the long position (in the trend direction) might be entered first, followed by the short leg within a few minutes or a few days. If the maitet is trending steadily, profits in the long position can be proterted when the short leg is entered Legging-in is a rewarding philosophy when it woits. When it doesnt woit, there is a large loss on the outright

FIGURE 13-12 Interdelivery spread volatility, (a) Actual prices, (b) Relatlonsh of interdelivery spreads.

Spread or neartiy and tarttwst deferred

position, which will be difficult to offset with the lower profits from the spread. If the piwpose of trading a spread is to reduce ride legging-in or legging-out is not going to accomplish that goal.

Protecting an existing trend position in the nearby month by spreading with the nexl deferred delivery is not as good as simply liquidating the initial position. If the maitet has been going up and indicates a temporary downturn, some traders will hedge by selling the first deferred contract. The result is a bull spread instead of an outright long. If the anticipation of a price reversal was correct, the trade rid; is reduced but there is atill a loss, if the decision was wrong, profits are reduced. Converting a potentially losing outright position into a potentially losing hedge changes the size of ttie loss or profit. It is much simpler to close out the position rather than defer the decision

When the trend tums from up to down, it is necessarj to switch the spread from bun to bear. If large profits have been made in the bull move and both the trend and spread signal a downward tum, it could be tempting to lift the long leg and hold the outright short using accrued profits to offset the increased risk. A more conservative trader might enter a bear spread in the first and second deferred months rather than the spot and first deferred, thereby reducing risk even further and allowing smaller profits-conserving prior success.

Reverse Response to Trending Maitets

Some spreads respond in just the opposite way to trends. For precious metals and potatoes, an upward trend results in the deferred contracts rising fader than the nearby. For example, consider the rising price of gold, which results in a larger total contract value and, consequently, a higher interest charge based on that value.

Traders familiar with the potato market will know that higher prices, which reflect greater demand and produa dissppearance, will result in critical tightness in the last winter trading month. The perishable potato crop must last to early June when the first spring potatoes reach the maitet. Early demand on the stored crop will magnify the volatility as end of spring spproaches. For both metals and potatoes, a bull spread can be entered by selling the nearby and

buying the deferred contracts. Exceptions to the Rules

During a trending period, most markets exhibit a clear relationship between delivery months. Cattle, hogs, broilers, and eggs are nonstorable, however, and show little relationship in the response of deferred contracts to the same bullish or bearish news.

During periods of exceptional demand, livestock may be mariceted early causing a strong similarity in the price pattems of catUe and hogs in the nearby contracts. Even in the most extreme cases, this pattem caimot be carried far into the future.

VOLATILITY AND SPREAD RATIOS

Higher price levels result in increased volatility in both individual maikets and their related spreads. Fast price movements and large swings associated with high price levels will create spread opportunities that are more profitable than normal; maikets with small movement are not candidates for spreads. The combination of two low-volatility maikets produces spreads with such small potential that execution costs often exceed the expected profits.

The two sides of a spread rarely have the same volatility. When badly mismatched, a spread will act the same as if you had taken an outright position in the more volatile side of the spread. For example. Figure 13-13a shows what appears to be an excellent spread relationship; however. Figure 13-13b reveals that the pattem is the result of two sideways maikets, one highly volatile (A) and the other with low volatility (S). Maiket offers little protection if maiket A were to move sha ly higher instead of sideways.

FIGURE 13-13 Poor spread selection, (aj Spread price, (bj Spread components

The same illustration would be sppropriate if a gold-silver spread were created by subtracting the price of silver from that of gold rather than taking aratio. Equal moves of 10°o in gold from $300 to $330 and silver from $6.00 to $6.60 would result in a spread price change from $294.00 to $323.40, effectively mirroring the gold change rather than maintaining an unchanged spread.

Spread Ratio

The markets which offer sound spread opportunities will varj in their absolute price range or volatility For example, during 1984, the price of spot live hog futures varied from 43.800 to 58.00c per pound, whereas pork bellies ranged from 54.700 to 74.iOc per pound. Both sppear to be consistent in volatility as seen from the ratios, yet more than a 50°o difference occurred in the size of the price change.

Had the ratio been seen to drop to 1. 15, a long bellies, short hogs spread would have been entered. If the ratio had moved to 1.35, a spread would have been entered to buy hogs and sell bellies. Assume that this distortion occurred at prices near the lows and that prices then adjusted to 1.27 at the highs shown in Table 13-2. There are two possible trades that might have occurred:

TABLE 13-2 Price Movement of Poric Bellies and Live Hogs in 1984