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Today's Featured Article
Over the past year governments around the world have taken measures to try to improve world economies, leading to unprecedented volatility in currency markets. This volatility has caused the frustrations of nearly every trader that has tried to take a position in any market, whether it was corn, crude, or gold.
The most recent incident of this happened after the markets closed on Thursday, February 19th. As any trader that had a position on at that time knows, the Federal Reserve's decision to raise its discount rate caused a spike in the US$ index and a sharp sell-off in pretty much every other market. With the overnight bank lending rate still near zero, and mortgage rates near record lows, market participants need to prepare themselves for similar announcements in the future. These expected announcements not only will have a major affect on futures prices, but more importantly to individual investors, have a major affect on the account value of any traders holding positions.
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So how does one hedge themselves in anticipation of more announcements such as this? There are a few ways traders can enter positions that somewhat limit risk in the event of an unexpected event causing volatile market swings. While long options are a good tool to limit risk, in times of high volatility, the cost associated with the options can become prohibitive. One tool commonly used by professional traders to limit portfolio risk is an intermarket spread.
Intermarket spreads involve the purchase of one commodity and the sale of another. A popular intermarket spread in the grain trade is the KC/Chicago wheat spread. Traders either enter a long KC wheat and short Chicago wheat position or vice versa, expecting the value of KC wheat to either rise or fall in relation to the price of Chicago wheat. On a day when the US$ is either unexpectedly sharply higher or lower, the dollar's affect on the two different contracts of wheat will be nearly the same. After the fed announcement on the 19th, May Chicago wheat traded a 12 3/4 cent range ($637.50), May KC wheat traded a 13 1/2 cent range ($675), while the KC/Chicago spread traded about a 3 cent
range ($150). The difference in trading ranges could have meant the difference between being stopped out, only to watch the market recover. Or, being able to stick with the trade and not have to deal with the frustration of being pushed out of the market all because the Fed decided to change the discount rate. |
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When trading intermarket spreads it is important to do some homework before entering the trade. Looking at the markets from a fundamental standpoint is a good place to start and helps to determine which contract you want to be long and which contract you want to be short. Next, it is a good idea to look for seasonal trends in the markets to assist you in the timing of your trade execution. Third, look at where the markets have been and have an idea of where you think prices may go. Finally, and most importantly, have an exit plan regardless of whether the trade goes your direction or not. The biggest mistake many traders make is letting a trade go so far against them that they cannot
recover from their losses, which leads to missed opportunities in the future.
Benefits of intermarket spreads: -
Protected from adverse swings in currency markets
- Lower margin requirement
- Less volatility in your trading portfolio
The wheat spread was just one example and this same strategy can be applied to trades in nearly every commodity.
Futures trading involves risk of loss and is not suitable for everyone. |
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About the Author
| Doug Bergman
is a broker with the Advantage Traders division of MF Global. Doug was first introduced into commodity markets growing up on his family's grain and livestock farm in central Illinois. Due to his background, Doug specializes in the agricultural markets, producing multiple research reports throughout the trading day providing fundamental research reports along with both long and short-term trade recommendations. |
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