4
A Complete Guide to the Futures mArket
The essence of afutures market is in its name: Trading involves acommodity or financial
instrument for afuture delivery date, as opposed to the present time. Thus, if acotton farmer
wished to make acurrent sale, he would sell his crop in the local cash market. However, if the
same farmer wanted to lock in aprice for an anticipated future sale (e.g., the marketing of astill
unharvested crop), he would have two options: He could locate an interested buyer and negotiate
acontract specifying the price and other details (quantity, quality, delivery time, location, etc.).
alternatively, he could sell futures. some of the major advantages of the latter approach are the
following:
 1. The futures contract is standardized; hence, the farmer does not have to find aspecific buyer.
 2. The transaction can be executed virtually instantaneously online.
 3. The cost of the trade (commissions) is minimal compared with the cost of an individualized
forward contract.
 4. The farmer can offset his sale at any time between the original transaction date and the final
trading day of the contract. The reasons this may be desirable are discussed later in this chapter.
 5. The futures contract is guaranteed by the exchange.
Until the early 1970s, futures markets were restricted to commodities (e.g., wheat, sugar,
copper, cattle). since that time, the futures area has expanded to incorporate additional market sec-
tors, most significantly stock indexes, interest rates, and currencies (foreign exchange). The same
basic principles apply to these financial futures markets. Trading quotes represent prices for afuture
expiration date rather than current market prices. For example, the quote for December 10-year
T -note futures implies aspecific price for a $100,000, 10-year U.
s. Treasury note to be delivered
in December. Financial markets have experienced spectacular growth since their introduction, and
today trading volume in these contracts dwarfs that in commodities.
nevertheless, futures markets
are still commonly, albeit erroneously, referred to as commodity markets, and these terms are
synonymous.
 ■ Delivery
shorts who maintain their positions in deliverable futures contracts after the last trading day
are obligated to deliver the given commodity or financial instrument against the contract. similarly,
longs who maintain their positions after the last trading day must accept delivery. in the com-
modity markets, the number of open long contracts is always equal to the number of open short
contracts (see section Volume and Open
interest). Most traders have no intention of making
or accepting delivery, and hence will offset their positions before the last trading day. (The
long offsets his position by entering asell order, the short by entering abuy order.)
it has been
estimated that fewer than 3 percent of open contracts actually result in delivery. some futures
contracts (e.g., stock indexes, eurodollar) use acash settlement process whereby outstanding long
and short positions are offset at the prevailing price level at expiration instead of being physically
delivered.

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5FOr Beginners Only
 ■ Contract Specifications
Futures contracts are traded for awide variety of markets on anumber of exchanges both in the
United states and abroad. The specifications for these contracts, especially details such as daily price
limits, trading hours, and ticker symbols, can change over time; exchange web sites should be con-
sulted for up-to-date information. Table 1.1 provides the following representative trading details for
six futures markets (
e-mini s&P 500, 10-year T -note, euro, Brent crude oil, corn, and gold):
 1. exchange. note that some markets are traded on more than one exchange. in some cases,
different contracts for the same commodity (or financial instrument) may even be traded on the
same exchange.
 2. ticker symbol. The quote symbol is the letter code that identifies each market (e.g., es for
the e-mini s&P 500, Cfor corn, eC for the euro), combined with an alphanumeric suffix to
represent the month and year.
 3. Contract size. The specification of auniform quantity per contract is one of the key ways in
which afutures contract is standardized. By multiplying the contract size by the price, the trader
can determine the dollar value of acontract. For example, if corn is trading at $4.00/bushel (bu),
the contract value equals $20,000 ($4 × 5,000 bu per contract).
if Brent crude oil is trading at
$48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor-
tant exceptions, very roughly speaking, higher per-contract dollar values will imply agreater
potential/risk level. (The concept of contract value has no meaning for interest rate contracts.)
 4. Price quoted in. This row indicates the relevant unit of measure for the given market.
 5. Minimum price fluctuation (“tick”) size and value. This row indicates the minimum
increment in which prices can trade, and the dollar value of that move. For example, the mini-
mum fluctuation for the
e-mini s&P 500 contract is 0.25 index points. Thus, you can enter an
order to buy December e-mini s&Pfutures at 1,870.25 or 1,870.50, but not 1,870.30. The
minimum fluctuation for corn is 1
4 ¢/bu, which means you can enter an order to buy December
corn at $4.01 1
2 or $4.01 3
4 , but not $4.01 5
8 per bushel. The tick value is obtained by multiply-
ing the minimum fluctuation by the contract size. For example, for Brent crude oil, one cent
($0.01) per barrel × 1,000 barrels = $10. For corn,
1
4 50 00 12 50¢/bu ×=,$ ..
 6. Contract months. each market is traded for specific months. For example, the e-mini s&P
500 futures contract is traded for March, June, september, and December. Corn is traded for
March, May, July, september, and December. Table 1.2 shows the letter designations for each
month of the year, which are added (along with the contract year) to amarket’sbase ticker
symbol to create acontract-specific ticker symbol. For example, December 2017
e-mini s&P
500 futures have aticker symbol of esZ17, while the symbol for the March 2018 contract is
esH18. The symbol for May 2017 corn is CK17. The last trading day for acontract typically
occurs on aspecified date in the contract month, although in some markets (such as crude oil),
the last trading day falls in the month preceding the contract month. For most markets, futures
are listed for contract months at least one year forward from the current date. However, trading
activity is normally heavily concentrated in the nearest two contracts.

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7FOr Beginners Only
Daily Price limit 7%, 13%, and 20%
limits are applied
to the futures fixing
price, effective 8:30
a.m. to 3 p.m. CT ,
Mon–Fri.
7%, 13%, and 20% limits are
applied to the futures fixing
price, effective 8:30 a.m. to
3 p.m. CT , Mon–Fri. (
see
exchange for specifics.)
n/an/a $0.25 n/a
Settlement type Cash settlement Deliverable Deliverable Physical delivery based
on eFP delivery, with
an option to cash settle
against the
iCe Brent
index price for the
last trading day of the
futures contract.
Deliverable Deliverable
First Notice Day
n/a Final business day of the
month preceding the
contract month.
n/an/alast business day of
month preceding
contract month.
The last business day of the
month preceding the delivery
month.
last Notice Day n/a Final business day of the
contract month.
n/an/a The business day after
the last contract’slast
trading day.
The second-to-last business
day of the delivery month.
last trading Day Until 8:30 a.m. on
the 3rd Friday of the
contract month.
12:01 p.m. on the 7th
business day preceding
the last business day of the
delivery month.
9:16 a.m. CT on
the second business
day immediately
preceding the
third Wed of the
contract month.
The last business day
of the second month
preceding the relevant
contract month.
Business day prior to
the 15th calendar day of
the contract month.
The third-to-last business day
of the delivery month.
Deliverable
Grade
n/a U.s. T -notes with aremaining
term to maturity of 6.5 to 10
years from the first day of the
delivery month.
n/an/a #2 yellow at contract
price, #1 yellow at
a 1.5 cent/bushel
premium, #3
yellow
at a 1.5 cent/bushel
discount.
gold delivered under this
contract shall assay to aminimum of 995 fineness.
7

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9FOr Beginners Only
approaching expiration (frequently first notice day—see item 10). Daily price limits can change
frequently, so traders should consult the exchange on which their products trade to ensure they
are aware of current thresholds.
 9. Settlement type. Markets are designated either as physically deliverable or cash settled. in
Table 1.1, the e-mini s&P 500 futures are cash settled, while all the other markets can be physi-
cally delivered.
 10. First notice day. This is the first day on which along can receive adelivery notice. First notice
day presents no problem for shorts, since they are not obligated to issue anotice until after the
last trading day. Furthermore, in some markets, first notice day occurs after last trading day,
presenting no problem to the long either, since all remaining longs at that point presumably
wish to take delivery. However, in markets in which first notice day precedes last trading day,
longs who do not wish to take delivery should be sure to offset their positions in time to avoid
receiving adelivery notice. (Brokerage firms routinely supply their clients with alist of these
important dates.)
although longs can pass on an undesired delivery notice by liquidating their
position, this transaction will incur extra transaction costs and should be avoided. Last notice
day is the final day along can receive adelivery notice.
 11. last trading day. This is the last day on which positions can be offset before delivery becomes
obligatory for shorts and the acceptance of delivery obligatory for longs. as indicated previously,
the vast majority of traders will liquidate their positions before this day.
 12. Deliverable grade. This is the specific quality and type of the underlying commodity or finan-
cial instrument that is acceptable for delivery.
 ■ Volume and Open Interest
Volume is the total number of contracts traded on agiven day. Volume figures are available for each
traded month in amarket, but most traders focus on the total volume of all traded months.
Open interest is the total number of outstanding long contracts, or equivalently, the total number
of outstanding short contracts—in futures, the two are always the same. When anew contract begins
trading (typically about 12 to 18 months before its expiration date), its open interest is equal to zero.
if abuy order and sell order are matched, then the open interest increases to 1. Basically, open interest
increases when anew buyer purchases from anew seller and decreases when an existing long sells to
an existing short. The open interest will remain unchanged if anew buyer purchases from an existing
long or anew seller sells to an existing short.
Volume and open interest are very useful as indicators of amarket’sliquidity.
not all listed futures mar-
kets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading
activity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the
trader will often have to accept very poor trade execution prices if he wants to get in or out of aposition.
generally speaking, markets with open interest levels below 5,000 contracts, or average daily
volume levels below 1,000 contracts, should be avoided, or at least approached very cautiously.
new markets will usually exhibit volume and open interest figures below these levels during their

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10a COMPleTe gUiDe TO THe FUTUres MarKeT
initial months (and sometimes even years) of trading. By monitoring the volume and open interest
fi gures, atrader can determine when the market’slevel of liquidity is suffi cient to warrant participa-
tion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with
their respective daily volume fi gures. February gold’svolume is negligible until november 2015,
at which point it increases rapidly into December and maintains ahigh level through January (the
February contract expires in late February). Meanwhile, april gold’svolume is minimal until Janu-
ary, at which point it increases steadily and becomes the more actively traded contract in the last
two days of January—even though the February gold contract is still amonth from expiration at
that point.
 The breakdown of volume and open interest fi gures by contract month can be very useful in
determining whether aspecifi cmonth is suffi ciently liquid. For example, atrader who prefers to
initiate along position in anine-month forward futures contract rather than in more nearby con-
tracts because of an assessment that it is relatively underpriced may be concerned whether its level
of trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and
open interest fi gures by contract month can help the trader decide whether it is reasonable to enter
the position in the more forward contract or whether it is better to restrict trading to the nearby
contracts.
 Traders with short-term time horizons (e.g., intraday to afew days) should limit trading to the
most liquid contract, which is usually the nearby contract month.
 FIGURE  1.1 Volume shift in gold Futures
Chart created using Tradestation. ©Tradestation Technologies, inc. all rights reserved.

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15FOr Beginners Only
this wide discount, the hedge is still very profitable because the price differential is ultimately
far outweighed by the intervening price decline. Thus, the relevant question is not whether the
futures-implied cash price is attractive relative to the current cash price, but rather whether it is
attractive relative to the expected future cash price.
 6. The hedger does not precisely lock in atransaction price. His effective price will depend on
the basis. For example, if the cotton producer sells futures at 85¢/lb, assuming a −3¢ basis, his
effective sales price will be 80¢/lb, rather than the anticipated 82¢/lb, if the actual basis at the
time of offset is −5¢. However, it should be emphasized that this basis-price uncertainty is far
smaller than the outright price uncertainty in an unhedged position. Furthermore, by using
reasonably conservative basis assumptions the hedger can increase the likelihood of achieving,
or bettering, the assumed locked-in price.
 7. although ahedger plans to buy or sell the actual commodity, it will usually be far more efficient
to offset the futures position and use the local cash market for the actual transaction. Futures
should be viewed as apricing tool, not as avehicle for making or taking delivery.
 8. Most standard discussions of hedging make no mention whatsoever of price forecasting.
This omission seems to imply that hedgers need not be concerned about the direction of
prices.
although this conclusion may be valid for some hedgers (e.g., amiddleman seek-
ing to lock in aprofit margin between the purchase and sales price), it is erroneous for
most hedgers. There is little sense in following an automatic hedging program.
rather,
the hedger should evaluate the relative attractiveness of the price protection offered by
futures. Price forecasting would be akey element in making such an evaluation.
in this
respect, it can easily be argued that price forecasting is as important to many hedgers as it
is to speculators.
 ■ Trading
The trader seeks to profit by anticipating price changes. For example, if the price of December gold
is $1,150/oz, atrader who expects the price to rise above $1,250/oz will go long. The trader has
no intention of actually taking delivery of the gold in December.
right or wrong, the trader will
offset the position sometime before expiration. For example, if the price rises to $1,275 and the
trader decides to take profits, the gain on the trade will be $12,500 per contract (100 oz × $125/
oz).
if, on the other hand, the trader’sforecast is wrong and prices decline to $1,075/oz, with the
expiration date drawing near, the trader has little choice but to liquidate. in this situation, the loss
would be equal to $7,500 per contract. note that the trader would not take delivery even given
adesire to maintain the long gold position. in this case, the trader would liquidate the December
contract and simultaneously go long in amore forward contract. (This type of transaction is called
arollover and would be implemented with aspread order—defined in the next section.) Traders
should avoid taking delivery, since it can often result in substantial extra costs without any com-
pensating benefits.

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19FOr Beginners Only
Spread
aspread involves the simultaneous purchase of one futures contract against the sale of another futures
contract, either in the same market or in arelated market. in essence, aspread trader is primarily
concerned with the difference between prices rather than the direction of price. an example of aspread
trade would be: Buy 1 July cotton/sell 1 December cotton, July 200 points premium December.
This order would be executed if July could be bought at aprice 200 points or less above the level at
which December is sold.
such an order would be placed if the trader expected July cotton to widen
its premium relative to December cotton.
not all brokerages will accept all the order types in this section (and may offer others not listed here).
Traders should consult with their brokerage to determine which types of orders are available to them.
 ■ Commissions and Margins
in futures trading, commissions are typically charged on aper-contract basis. in most cases, large
traders will be able to negotiate areduced commission rate. although commodity commissions are
relatively moderate, commission costs can prove substantial for the active trader—an important rea-
son why position trading is preferable unless one has developed avery effective short-term trading
method.
Futures margins are basically good-faith deposits and represent only asmall percentage of the con-
tract value (roughly 5 percent with some significant variability around this level). Futures exchanges
will set minimum margin requirements for each of their contracts, but many brokerage houses will
frequently require higher margin deposits.
since the initial margin represents only asmall portion of
the contract value, traders will be required to provide additional margin funds if the market moves
against their positions. These additional margin payments are referred to as maintenance.
Many traders tend to be overly concerned with the minimum margin rate charged by abroker-
age house.
if atrader is adhering to prudent money management principles, the actual margin level
should be all but irrelevant. as ageneral rule, the trader should allocate at least three to five times
the minimum margin requirement to each trade. Trading an account anywhere near the full margin
allowance greatly increases the chances of experiencing asevere loss. Traders who do not maintain at
least several multiples of margin requirements in their accounts are clearly overtrading.
 ■ Tax Considerations
 Tax laws change over time, but for the average speculator in the United states, the essential elements
of the futures contract tax regulations can be summarized in three basic points:
 1. There is no holding period for futures trades (i.e., all trades are treated equally, regardless of the
length of time aposition is held, or whether aposition is long or short).

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45
Chapter 5
 ■ The Necessity of Linked-Contract Charts
Many of the chart analysis patterns and techniques detailed in Chapters 6 through 9 require long-
term charts—often charts of multiyear duration. This is particularly true for the identification of top
and bottom formations, as well as the determination of support and resistance levels.
Amajor problem facing the chart analyst in the futures markets is that most futures contracts
have relatively limited life spans and even shorter periods in which these contracts have significant
trading activity. For many futures contracts (e.g., currencies, stock indexes) trading activity is almost
totally concentrated in the nearest one or two contract months. For example, in Figure 5.1, there
were only about two months of liquid data available for the March 2016 Russell 2000 Index Mini
futures contract when it became the most liquid contract in this market as the December 2015 con -
tract expiration approached. This market is not particularly unusual in this respect. In many futures
markets, almost all trading is concentrated in the nearest contract, which will have only afew months
(or weeks) of liquid trading history when the prior contract approaches expiration.
Linking Contracts
for Long- Term
Chart Analysis:
Nearest versus
Continuous Futures

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46A COMPLETE GUIDE TO THE FUTURES MARKET
 The limited price data available for many futures contracts—even those that are the most actively
traded contracts in their respective markets—makes it virtually impossible to apply most chart analy-
sis techniques to individual contract charts. Even in those markets in which the individual contracts
have ayear or more of liquid data, part of athorough chart study would still encompass analyzing
multiyear weekly and monthly charts. Thus, the application of chart analysis unavoidably requires
linking successive futures contracts into asingle chart. In markets with very limited individual con-
tract data, such linked charts will be anecessity in order to perform any meaningful chart analysis. In
other markets, linked charts will still be required for analyzing multiyear chart patterns.
 ■ Methods of Creating Linked-Contract Charts
 Nearest Futures
 The most common approach for creating linked-contract charts is typically termed nearest futures. This
type of price series is constructed by taking each individual contract series until its expiration and
then continuing with the next contract until its expiration, and so on.
 Although, at surface glance, this approach appears to be areasonable method for constructing
linked-contract charts, the problem with anearest futures chart is that there are price gaps between
expiring and new contracts—and quite frequently, these gaps can be very substantial. For exam-
ple, assume the September coff ee contract expires at 132.50 cents/lb and the next nearest con-
tract (December) closes at 138.50 cents/lb on the same day. Further assume that on the next day
 FIGURE  5.1 March 2016 Russell 2000 Mini Futures
Chart created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved.

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47
Linking ContraCts for Long-term Chart anaLysis
December coffee falls 5 cents/lb to 133.50—a 3.6 percent drop. Anearest futures price series will
show the following closing levels on these two successive days: 132.50 cents, 133.50 cents. In other
words, the nearest futures contract would show aone-cent (0.75 percent) gain on aday on which longs
would actually have experienced ahuge loss. This example is by no means artificial. Such distortions—
and indeed more extreme ones—are quite common at contract rollovers in nearest futures charts.
The vulnerability of nearest futures charts to distortions at contract rollover points makes it desir-
able to derive alternative methods of constructing linked-contract price charts. One such approach
is detailed in the next section.
Continuous (Spread-adjusted) price Series
The spread-adjusted price series known as “continuous futures” is constructed by adding the cumulative dif-
ference between the old and new contracts at rollover points to the new contract series.
1 An example should
help clarify this method. Assume we are constructing aspread-adjusted continuous price series for gold
using the June and December contracts.
2 If the price series begins at the start of the calendar year, initially the
values in the series will be identical to the prices of the June contract expiring in that year. Assume that on the
rollover date (which need not necessarily be the last trading day) June gold closes at $1,200 and December
gold closes at $1,205. In this case, all subsequent prices based on the December contract would be adjusted
downward by $5—the difference between the December and June contracts on the rollover date.
Assume that at the next rollover date December gold is trading at $1,350 and the subsequent June
contract is trading at $1,354. The December contract price of $1,350 implies that the spread-adjusted
continuous price is $1,345. Thus, on this second rollover date, the June contract is trading $9 above the
adjusted series. Consequently, all subsequent prices based on the second June contract would be adjusted
downward by $9. This procedure would continue, with the adjustment for each contract dependent on the
cumulative total of the present and prior transition point price differences. The resulting price series would
be free of the distortions due to spread differences that exist at the rollover points between contracts.
The construction of acontinuous futures series can be thought of as the mathematical equivalent
of taking anearest futures chart, cutting out each individual contract series contained in the chart,
and pasting the ends together (assuming acontinuous series employing all contracts and using the
same rollover dates as the nearest futures chart). Typically, as alast step, it is convenient to shift the
scale of the entire series by the cumulative adjustment factor, astep that will set the current price
of the series equal to the price of the current contract without changing the shape of the series. The
construction of acontinuous futures chart is discussed in greater detail in Chapter 18.
1 Toavoid confusion, readers should note that some data services use the term continuous futures to refer to linking
together contracts of the same month (e.g., linking from March 2015 corn when it expires to March 2016 corn,
and so on). Such charts are really only avariation of nearest futures charts—one in which only asingle contract
month is used—and will be as prone to wide price gaps at rollovers as nearest futures charts, if not more so.
These types of charts have absolutely nothing in common with the spread-adjusted continuous futures series
described in this section—that is, nothing but the name. It is unfortunate that some data services have decided
to use this same term to describe an entirely different price series than the original meaning described here.
2 The choice of acombination of contracts is arbitrary. One can use any combination of actively traded months
in the given market.

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280
A Complete Guide to the Futures mArket
series. For example, a 15year test run for atypical market would require using approximately 60 to
90 individual contract price series. Moreover, using the individual contract series requires an algo
rithm for determining what action to take at the rollover points. As an example of the type of problem
that may be encountered, it is entirely possible for agiven system to be long in the old contract and
short in the new contract or vice versa. These problems are hardly insurmountable, but they make the
use of individual contract series asomewhat unwieldy approach.
The awkwardness involved in using amultitude of individual contracts is not, however, the main
problem. The primary drawback in using individual contract series is that the period of meaningful
liquidity in most contracts is very short—much shorter than the already limited contract life spans.
Tosee the scope of this problem, examine across section of futures price charts depicting the price
action in the one
year period prior to expiration. In many markets, contracts don’tachieve meaning
ful liquidity until the final five or six months of trading, and sometimes even less. This problem was
illustrated in Chapter 5. The limited time span of liquid trading in individual contracts means that any
technical system or method that requires looking back at more than about six months of data—as
would be true for awhole spectrum of longer
term approaches—cannot be applied to individual
contract series. Thus, with the exception of shortterm system traders, the use of individual contract
series is not aviable alternative. It’snot merely amatter of the approach being difficult but, rather, its
being impossible because the necessary data simply do not exist.
 ■ Nearest Futures
The problems in using individual contract series as just described has led to the construction of vari
ous linked price series. The most common approach is almost universally known as nearest futures.
This price series is constructed by taking each individual contract series until its expiration and then
continuing with the next contract until its expiration, and so on. This approach may be useful for
constructing long
term price charts for purposes of chart analysis, but it is worthless for providing aseries that can be used in the computer testing of trading systems.
The problem in using anearest futures series is that there are price gaps between expiring and new
contracts—and quite frequently these gaps can be very substantial. For example, assume the July corn
contract expires at $4 and that the next nearest contract (September) closes at $3.50 on the same day.
Assume that on the next day September corn moves from $3.50 to $3.62. Anearest futures price series
will show the following closing levels on these two successive days: $4, $3.62. In other words, the near
est futures contract would imply a 38
cent loss on aday on which longs would have enjoyed (or shorts
would have suffered) aprice gain of 12 cents. This example is by no means artificial. In fact, it would
be easy to find aplethora of similarly extreme situations in actual price histories. Moreover, even if the
typical distortion at rollover is considerably less extreme, the point is that there is virtually always some
distortion, and the cumulative effect of these errors would destroy the validity of any computer test.
Fortunately, few traders are naive enough to use the nearest futures type of price series for computer
testing. The two alternative linked price series described in the next sections have become the approaches
employed by most traders wishing to use asingle price series for each market in computer testing.

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281
SElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg
 ■ Constant-Forward (“Perpetual”) Series
The constantforward (also known as “perpetual”) price series consists of quotes for prices aconstant
amount of time forward. The interbank currency market offers actual examples of constantforward
price series. For example, the threemonth forward price series for the euro represents the quote for
the euro three months forward from each given day in the series. This is in contrast to the standard
u.S. futures contract, which specifies afixed expiration date.
Aconstant forward series can be constructed from futures price data through interpola
tion. For example, if we were calculating a 90 day constant forward (or perpetual) series and
the 90day forward date fell exactly one third of the way between the expirations of the nearest
two contracts, the constant forward price would be calculated as the sum of two thirds of the
nearest contract price and one third of the subsequent contract price. As we moved forward in
time, the nearer contract would be weighted less, and the weighting of the subsequent contract
would increase proportionately. Eventually, the nearest contract would expire and drop out of
the calculation, and the constant
forward price would be based on an interpolation between the
subsequent two contracts.
As amore detailed example, assume you want to generate a 100day forward price series based on
euro futures, which are traded in March, June, September, and December contracts. Toillustrate the
method for deriving the 100
day constantforward price, assume the current date is January 20. In
this case, the date 100 days forward is April 30. This date falls between the March and June contracts.
Assume the last trading dates for these two contracts are March 14 and June 13, respectively. Thus,
April 30 is 47 days after the last trading day for the March contract and 44 days before the last trad
ing day for the June contract. Tocalculate the 100
day forward price for January 20, an average price
would be calculated using the quotes for March and June euro futures on January 20, weighting each
quote in inverse proportion to its distance from the 100
day forward date (April 30). Thus, if on Janu
ary 20 the closing price of March futures is 130.04 and the closing price of June futures is 130.77, the
closing price for the 100
day forward series would be:
44
91 1300 4 130 77 130 42(. )( .) .+=47
91
Note that the general formula for the weighting factor used for each contract price is:
W CF
CC W FC
CC1
2
21
2
1
21
= −
− = −
−
where C1 = number of days until the nearby contract expiration
 C2 = number of days until the forward contract expiration
 F = number of days until forward quote date
 W1 = weighting for nearby contract price quote
 W2 = weighting for forward contract price quote

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So, for example, the weightings of the March and June quotes that would be used to derive a
100day forward quote on March 2 would be as follows:
Weighting for March quot e
Weighting for
 = −
− =1031 00
103 12
3
91
JJune quote = −
− =100 12
103 12
88
91
As we move forward in time, the nearer contract is weighted less and less, but the weighting for
the subsequent contract increases proportionately. When the number of days remaining until the
expiration of the forward contract equals the constant forward time (100 days in this example), the
quote for the constant forward series would simply be equal to the quote for the forward contract
(June). Subsequent price quotes would then be based on aweighted average of the June and Septem
ber prices. In this manner, one continuous price series could be derived.
The constant
forward price series eliminates the problem of huge price gaps at rollover points and
is certainly asignificant improvement over anearest futures price series. However, this type of series
still has major drawbacks. Tobegin, it must be stressed that one cannot literally trade aconstant

forward series, since the series does not correspond to any real contract. An even more serious
deficiency of the constant
forward series is that it fails to reflect the effect of the evaporation of time
that exists in actual futures contracts. This deficiency can lead to major distortions—particularly in
carrying
charge markets.
Toillustrate this point, consider ahypothetical situation in which spot gold prices remain stable at
approximately $1,200/ounce for aoneyear period, while forward futures maintain aconstant pre
mium of 1 percent per twomonth spread. given these assumptions, futures would experience asteady
downtrend, declining $73.82/ounce1 ($7,382 per contract) over the oneyear period (the equivalent
of the cumulative carryingcharge premiums). Note, however, the constantforward series would com
pletely fail to reflect this bear trend because it would register an approximate constant price. For
example, atwo
month constantforward series would remain stable at approximately $1,212/ounce
(1.01 × $1,200 = $1,212). Thus, the price pattern of aconstant forward series can easily deviate
substantially from the pattern exhibited by the actual traded contracts—ahighly undesirable feature.
 ■ Continuous (Spread-Adjusted) Price Series
The spreadadjusted futures series, commonly known as continuous futures, is constructed to elimi
nate the distortions caused by the price gaps between consecutive futures contracts at their transi
tion points. In effect, the continuous futures price will precisely reflect the fluctuations of afutures
position that is continuously rolled over to the subsequent contract Ndays before the last trading
day, where Nis aparameter that needs to be defined. If constructing their own continuous futures
data series, traders should select avalue of Nthat corresponds to their actual trading practices.
1 This is true since, given the assumptions, the oneyear forward futures price would be approximately $1,273.82
(1.016 × $1,200 = $1,273.82) and would decline to the spot price ($1,200) by expiration.

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SElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg
For example, if atrader normally rolls aposition over to anew contract approximately 20 days before
the last trading day, Nwould be defined as 20. The scale of the continuous futures series is adjusted so
the current price corresponds to acurrently traded futures contract.
Table 18.1 illustrates the construction of acontinuous futures price for the soybean market. For
simplicity, this example uses only two contract months, July and November; however, acontinuous
price could be formed using any number of traded contract months. For example, the continuous futures
price could be constructed using the January, March, May, July, August, September, and November
soybean contracts.
table 18.1 Construction of a Continuous Futures price Using July and November Soybeans
(cents/bushel)*
Date Contract actual price
Spread at rollover
(Nearby Forward)
Cumulative
adjustment
Factor
Unadjusted
Continuous Futures
(Col. 3 + Col. 5)
Continuous
Futures price
(Col. 6 – 772.5)
6/27/12 Jul 12 1,471 1,471 698.5
6/28/12 Jul 12 1,466 1,466 693.5
6/29/12 Jul 12 1,512.75 1,512.75 740.25
7/2/12 Nov 12 1,438 85 85 1,523 750.5
7/3/12 Nov 12 1,474.75 85 1,559.75 787.25
***
10/30/12 Nov 12 1,533.75 85 1,618.75 846.25
10/31/12 Nov 12 1,547 85 1,632 859.5
11/1/12 Jul 13 1,474 86.25 171.25 1,645.25 872.75
11/2/12 Jul 13 1,454 171.25 1,625.25 852.75
***
6/27/13 Jul 13 1,548.5 171.25 1,719.75 947.25
6/28/13 Jul 13 1,564.5 171.25 1,735.75 963.25
7/1/13 Nov 13 1,243.25 312.5 483.75 1,727 954.5
7/2/13 Nov 13 1,242.5 483.75 1,726.25 953.75
***
10/30/13 Nov 13 1,287.5 483.75 1,771.25 998.75
10/31/13 Nov 13 1,280.25 483.75 1,764 991.5
11/1/13 Jul 14 1,224.5 45.5 529.25 1,753.75 981.25
11/4/13 Jul 14 1,227.75 529.25 1,757 984.5
***
6/27/14 Jul 14 1,432 529.25 1,961.25 1,188.75
6/30/14 Jul 14 1,400.5 529.25 1,929.75 1,157.25
7/1/14 Nov 14 1,147.5 243.25 772.5 1,920 1,147.5
7/2/14 Nov 14 1,141.5 772.5 1,914 1,141.5
*Assumes rollover on last day of the month preceding the contract month.

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For the moment, ignore the last column in Table 18.1 and focus instead on the unadjusted con
tinuous futures price (column 6). At the start of the period, the actual price and the unadjusted
continuous futures price are identical. At the first rollover point, the forward contract (November
2012) is trading at an 85
cent discount to the nearby contract (July 2012). All subsequent prices of
the November 2012 contract are then adjusted upward by this amount (the addition of apositive
nearby/forward spread), yielding the unadjusted continuous futures prices shown in column 6. At
the next rollover point, the forward contract (July 2013) is trading at an 86.25
cent discount to the
nearby contract (November 2012). As aresult, all subsequent actual prices of the July 2013 contract
must now be adjusted by the cumulative adjustment factor—the total of all rollover gaps up to that
point (171.25 cents)—in order to avoid any artificial price gaps at the rollover point. This cumulative
adjustment factor is indicated in column 5. The unadjusted continuous futures price is obtained by
adding the cumulative adjustment factor to the actual price.
The preceding process is continued until the current date is reached. At this point, the final cumu
lative adjustment factor is subtracted from all the unadjusted continuous futures prices (column 6),
astep that sets the current price of the series equal to the price of the current contract (November
2014 in our example) without changing the shape of the series. This continuous futures price is indi
cated in column 7 of Table 18.1. Note that although actual prices seem to imply anet price decline of
329.50 cents during the surveyed period, the continuous futures price indicates a 443
cent increase—
the actual price change that would have been realized by aconstant long futures position.
In effect, the construction of the continuous series can be thought of as the mathematical equiva
lent of taking anearest futures chart, cutting out each individual contract series contained in the
chart, and pasting the ends together (assuming acontinuous series employing all contracts and using
the same rollover dates as the nearest futures chart).
In some markets, the spreads between nearby and forward contracts will range from premiums to
discounts (e.g., cattle). However, in other markets, the spread differences will be unidirectional. For
example, in the gold market, the forward month always trades at apremium to the nearby month.
2 In
these types of markets, the spreadadjusted continuous price series can become increasingly disparate
from actual prices.
It should be noted that when nearby premiums at contract rollovers tend to swamp nearby dis
counts, it is entirely possible for the series to eventually include negative prices for some past periods
as cumulative adjustments mount, as illustrated in the soybean continuous futures chart in Figure 18.1.
The price gain that would have been realized by acontinuously held futures position during this period
2 The reason for this behavioral pattern in gold spreads is related to the fact that world gold inventories exceed
annual usage by many multiples, perhaps even by as much as ahundredfold. Consequently, there can never ac
tually be a “shortage” of gold—and ashortage of nearby supplies is the only reason why astorable commodity
would reflect apremium for the nearby contract. (Typically, for storable commodities, the fact that the forward
contracts embed carrying costs will result in these contracts trading at apremium to more nearby months.)
gold prices fluctuate in response to shifting perceptions of gold’svalue among buyers and sellers. Even when
gold prices are at extremely lofty levels, it does not imply any actual shortage, but rather an upward shift in the
market’sperception of gold’svalue. Supplies of virtually any level are still available—at some price. This is not
true for most commodities, in which there is adefinite relevant limit in total supplies.

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series means that past prices in acontinuous series will not match the actual historical prices that
prevailed at the time. However, the essential point is that the continuous series is the only linked
futures series that will exactly reflect price swings and hence equity fluctuations in an actual trading
account. Consequently, it is the only linked series that can be used to generate accurate simulations in
computer testing of trading systems.
The preceding point is absolutely critical! Mathematics is not amatter of opinion. There is one
right answer and there are many wrong answers. The simple fact is that if acontinuous futures price
series is defined so that rollovers occur on days consistent with rollovers in actual trading, results
implied by using this series will precisely match results in actual trading (assuming, of course, accu
rate commission and slippage cost estimates). In other words, the continuous series will exactly paral
lel the fluctuations of aconstantly held (i.e., rolled over) long position. All other types of linked series
will not match actual market price movements.
Toillustrate this statement, we compare the implications of various price series using the sideways
gold market example cited earlier in this chapter (i.e., gold hovering near $1,200 and aforward/
nearby contract premium equal to 1 percent per two
month spread). Atrader buying aoneyear for
ward futures contract would therefore pay approximately $1,273.82 (1.016 × $1,200 = $1,273.82).
The spot price would reflect asideways pattern near $1,200. As previously seen, a 60day constant
forward price would reflect asideways pattern near $1,212 (1.01 × $1,200). Anearest futures
price series would exhibit ageneral sideways pattern, characterized by extended minor downtrends
(reflecting the gradual evaporation of the carrying charge time premium as each nearby contract
approached expiration), interspersed with upward gaps at rollovers between expiring and subsequent
futures contracts.
Thus the spot, constant
forward, and nearest futures price series would all suggest that along
position would have resulted in abreakeven trade for the year. In reality, however, the buyer of the
futures contract pays $1,273.82 for acontract that eventually expires at $1,200. Thus, from atrading
or real
world viewpoint, the market actually witnesses adowntrend. The continuous futures price is
the only price series that reflects the market decline—and real dollar loss—atrader would actually
have experienced.
Ihave often seen comments or articles by industry “experts” arguing for the use of constant

forward (perpetual) series instead of continuous series in order to avoid distortions. This argument
has it exactly backwards. Whether these proponents of constant
forward series adopt their stance
because of naïveté or self interest (i.e., they are vendors of constant forwardtype data), they are
simply wrong. This is not amatter of opinion. If you have any doubts, try matching up fluctuations
in an actual trading account with those that would be implied by constant
forwardtype price series.
you will soon be abeliever.
Are there any drawbacks to the continuous futures time series? of course. It may be the best
solution to the linked series problem, but it is not aperfect answer. Aperfect alternative simply
does not exist.
one potential drawback, which is aconsequence of the fact that continuous futures
accurately reflect only price swings, not price levels, is that continuous futures cannot be used for any
type of percentage calculations. This situation, however, can be easily remedied. If asystem requires
the calculation of apercentage change figure, use continuous futures to calculate the nominal price

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 ■ Spreads—Definition and Basic Concepts
Aspread trade involves the simultaneous purchase of one futures contract against the sale of another
futures contract either in the same market or in arelated market. normally, the spread trader will
initiate aposition when he considers the price difference between two futures contracts to be out of
line rather than when he believes the absolute price level to be too high or too low .
in essence, the
spread trader is more concerned with the difference between prices than the direction of price. For
example, if atrader buys October cattle and sells February cattle, it would not make any difference to
him whether October rose by 500 points and February by only 400 points or October fell by 400 and
February fell by 500.
in either case, October would have gained 100 points relative to February, and
the trader’sprofit would be completely independent of the overall market direction.
However, this is not to say the spread trader will initiate atrade without having some definitive
bias as to the future outright market direction. in fact, very often the direction of the market will
determine the movement of the spread. in some instances, however, aspread trader may enter aposi-
tion when he has absolutely no bias regarding future market direction but views agiven price differ-
ence as being so extreme that he believes the trade will work, or at worst allow only amodest loss,
regardless of market direction. Wewill elaborate on the questions of when and how market direction
will affect spreads in later sections.
 ■ Why Trade Spreads?
the following are some advantages to not exclusively restricting one’strading to outright positions:
 1. In highly volatile markets, the minimum outright commitment of one contract
may offer excessive risk to small traders.
in such markets, one-day price swings in excess
of $1,500 per contract are not uncommon, and holding aone-contract position may well be
overtrading for many traders.
ironically, it is usually these highly volatile markets that provide
the best potential trading opportunities. spreads offer agreat flexibility in reducing risk to
adesirable and manageable level, since aspread trade usually presents only afraction of the
risk involved in an outright position.
1 For example, assume agiven spread is judged to involve
approximately one-fifth the risk of an outright position. in such acase, traders for whom aone-
contract outright position involves excessive risk may instead choose to initiate aone-, two-,
three-, or four-contract spread position, depending on their desired risk level and objectives.
 2. there are times when spreads may offer better reward/risk ratios than outright
positions. Of course, the determination of areward/risk ratio is asubjective matter. never-
theless, given atrader’smarket bias, in agiven situation spreads may sometimes offer abetter
means of approaching the market.
1 For some markets, reduced-size contracts are available on one or more exchanges.

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tHe COnCepts And MeCHAniCs OF spreAd trAding
 3. Spreads often offer some protection against sudden extreme losses due to dra-
matic events that may spark astring of limit-up or limit-down moves counter to
one’sposition (e.g., freeze, large export deal).
such situations are not all that infrequent,
and traders can sometimes lose multiples of the maximum loss they intended to allow (i.e., as
reflected by aprotective stop) before they can even liquidate their positions.
in contrast, during
atime of successive limit moves, the value of aspread might not even change as both months
may move the limit. Of course, eventually the spread will also react, but when it does, the
market may well be past its frenzied panic stage, and the move may be gradual and moderate
compared with the drastic price change of the outright position.
 4. aknowledge and understanding of spreads can also be avaluable aid in trading
outright positions. For example, afailure of the near months to gain sufficiently during arally (in those commodities in which again can theoretically be expected) may signal the trader
to be wary of an upward move as apossible technical surge vulnerable to retracement.
in other
words, the spread action may suggest that no real tightness exists. this scenario is merely one
example of how close observation of spreads can offer valuable insights into outright market
direction.
naturally, at times, the inferences drawn from spread movements may be mislead-
ing, but overall they are likely to be avaluable aid to the trader. Asecond way an understanding
of spreads can aid an outright-position trader is by helping identify the best contract month in
which to initiate aposition.
the trader with knowledge of spreads should have adistinct advan-
tage in picking the month that offers the best potential versus risk. Over the long run, this factor
alone could significantly improve trading performance.
 5. trading opportunities may sometimes exist for spreads at atime when none is
perceived for the outright commodity itself.
 ■ Types of Spreads
there are three basic types of spreads:
 1. the intramarket (or interdelivery) spread is the most common type of spread and con-
sists of buying one month and selling another month in the same commodity. An example of an
intramarket spread would be long
december corn/short March corn. the intramarket spread
is by far the most widely used type of spread and will be the focus of this chapter’sdiscussion.
the intercrop spread is aspecial case of the intramarket spread involving two different
crop years (e.g., long an old crop month and short anew crop month). the intercrop spread
requires special consideration and extra caution. intercrop spreads can often be highly volatile,
and price moves in opposite directions by new and old crop months are not particularly uncom-
mon.
the intercrop spread may often be subject to price ranges and patterns that distinctly
separate it from the intracrop spread (i.e., standard intramarket spread).
 2. the intercommodity spread consists of along position in one commodity and ashort
position in arelated commodity. in this type of spread the trader feels the price of agiven

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commodity is too high or low relative to aclosely related commodity. some examples of this
type of spread include long december cattle/short december hogs and long July wheat/short
July corn. The source/product spread, which involves acommodity and its by-product(s)—for
example, soybeans versus soybean meal and/or soybean oil—is aspecific type of intercommod-
ity spread that is sometimes classified separately.
usually, an intercommodity spread will involve the same month in each commodity, but
this need not always be the case. ideally, traders should choose the month they consider the
strongest in the market they are buying and the month they consider the weakest in the market
they are selling. Obviously, these will not always be the same month. For example, assume the
following price configuration:
December February april
Cattle 120.00 116.00 118.00
Hogs 84.00 81.00 81.00
given this price structure, atrader might decide the premium of cattle to hogs is too small
and will likely increase. this trading bias would dictate the initiation of along cattle/short hog
spread. However, the trader may also believe February cattle is underpriced relative to other
cattle months and that december hogs are overpriced relative to the other hog contracts. in
such acase, it would make more sense for the trader to be long February cattle/short decem-
ber hogs rather than long december cattle/short december hogs or long February cattle/short
February hogs.
One important factor to keep in mind when trading intercommodity spreads is that contract
sizes may differ for each commodity. For example, the contract size for euro futures is 125,000
units, whereas the contract size for British pound futures is 62,500 units.
thus, aeuro/British
pound spread consisting of one long contract could vary even if the price difference between
the two markets remained unchanged.
the difference in price levels is another important fac-
tor relevant to contract ratios for intercommodity spreads. the criteria and methodology for
determining appropriate contract ratios for intercommodity spreads are discussed in the next
chapter.
 3. the intermarket spread. this spread involves buying acommodity at one exchange and sell-
ing the same commodity at another exchange, which will often be another country. An example
of this type of spread would be long
new York March cocoa/short London March cocoa. trans-
portation, grades deliverable, distribution of supply (total and deliverable) relative to location,
and historical and seasonal basis relationships are the primary considerations in this type of
spread.
in the case of intermarket spreads involving different countries, currency fluctuations
become amajor consideration. intermarket spread trading is often referred to as arbitrage. As
arule, the intermarket spread requires agreater degree of sophistication and comprehensive
familiarity with the commodity in question than other types of spreads.

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 ■ The General Rule
For many commodities, the intramarket spread can often, but not always, be used as aproxy for an
outright long or short position. As ageneral rule, near months will gain ground relative to distant
months in abull market and lose ground in abear market.
the reason for this behavior is that abull
market usually reflects acurrent tight supply situation and often will place apremium on more imme-
diately available supplies.
in abear market, however, supplies are usually burdensome, and distant
months will have more value because they implicitly reflect the cost involved in storing the com-
modity for aperiod of time.
thus, if atrader expects amajor bull move, he can often buy anearby
month and sell amore distant month. if he is correct in his analysis of the market and abull move
does materialize, the nearby contract will likely gain on the distant contract, resulting in asuccess-
ful trade.
it is critical to keep in mind that this general rule is just that, and is meant only as arough
guideline. there are anumber of commodities for which this rule does not apply, and even in those
commodities where it does apply, there are important exceptions. Wewill elaborate on the question
of applicability in the next section.
At this point the question might legitimately be posed, “
if the success of agiven spread trade is
contingent upon forecasting the direction of the market, wouldn’tthe trader be better off with an
outright position?” Admittedly, the potential of an outright position will almost invariably be consid-
erably greater. But the point to be kept in mind is that an outright position also entails acorrespond-
ingly greater risk.
sometimes the outright position will offer abetter reward/risk ratio; at other
times the spread will offer amore attractive trade. Adetermination of which is the better approach
will depend upon absolute price levels, prevailing price differences, and the trader’ssubjective views
of the risk and potential involved in each approach.
 ■ The General Rule—Applicability and Nonapplicability
Commodities to Which the General rule Can Be applied
Commodities to which the general rule applies with some regularity include corn, wheat, oats,
soybeans, soybean meal, soybean oil, lumber, sugar, cocoa, cotton, orange juice, copper, and heating
oil. (
the general rule will also usually apply to interest rate markets.) Although the general rule will
usually hold in these markets, there are still important exceptions, some of which include:
 1. At agiven point in time the premium of anearby month may already be excessively wide, and
consequently ageneral price rise in the market may fail to widen the spread further.
 2. since higher prices also increase carrying costs (see section entitled “the Limited-risk spread”),
it is theoretically possible for aprice increase to widen the discount of nearby months in asurplus market. Although such aspread response to higher prices is atypical, its probability of
occurrence will increase in ahigh-interest-rate environment.

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 3. spreads involving aspot month near expiration can move independently of, or contrary to, the
direction implied by the general rule. the reason is that the price of an expiring position is criti-
cally dependent upon various technical considerations involving the delivery situation, and wide
distortions are common.
 4. Abull move that is primarily technical in nature may fail to influence awidening of the nearby
premiums since no real near-term tightness exists. (
such aprice advance will usually only be
temporary in nature.)
 5. government intervention (e.g., export controls, price controls, etc.), or even the expectation
of government action, can completely distort normal spread relationships.
therefore, it is important that when initiating spreads in these commodities, the trader keep in
mind not only the likely overall market direction, but also the relative magnitude of existing spread
differences and other related factors.
Commodities Conforming to the Inverse of the General rule
some commodities, such as gold and silver, conform to the exact inverse of the general rule: in aris-
ing market distant months gain relative to more nearby contracts, and in adeclining market they lose
relative to the nearby positions. In fact, in these markets, along forward/short nearby spread is often agood
proxy for an outright long position, and the reverse spread can be asubstitute position for an outright short.
in
each of these markets nearby months almost invariably trade at adiscount, which tends to widen in
bull markets and narrow in bear markets.
the reason for the tendency of near months in gold and silver to move to awider discount in abull market derives from the large worldwide stock levels of these metals. generally speaking, price
fluctuations in gold and silver do not reflect near-term tightness or surplus, but rather the market’schanging perception of their value.
in abull market, the premium of the back months will increase
because higher prices imply increased carrying charges (i.e., interest costs will increase as the total
value of the contract increases). Because the forward months implicitly contain the cost of carrying
the commodity, their premium will tend to widen when these costs increase. Although the preced-
ing represents the usual pattern, there have been afew isolated exceptions due to technical factors.
Commodities Bearing Little or No relationship to the General rule
Commodities in which there is little correlation between general price direction and spread differ-
ences usually fall into the category of nonstorable commodities (cattle and live hogs). Wewill exam-
ine the case of live cattle to illustrate why this there is no consistent correlation between price and
spread direction in nonstorable markets.
Live cattle, by definition, is acompletely nonstorable commodity. When feedlot cattle reach mar-
ket weight, they must be marketed; unlike most other commodities, they obviously cannot be placed
in storage to await better prices. (
to be perfectly accurate, cattle feeders have asmall measure of
flexibility, in that they can market an animal before it reaches optimum weight or hold it for awhile
after. However, economic considerations will place strong limits on the extent of such marketing

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shifts.) As aconsequence of the intrinsic nature of this commodity, different months in live cattle are,
in asense, different commodities. June live cattle is avery different commodity from december live
cattle. the price of each will be dependent on the market’sperception of the supply-demand picture
that it expects to prevail at each given time period. it is not unusual for akey cattle on feed report to
carry bullish implications for near months and bearish connotations for distant months, or vice versa.
in such acase, the futures market can often react by moving in opposite directions for the near and
distant contracts. the key point is that in abullish (bearish) situation, the market will sometimes view
the near-term supply/demand balance as being more bullish (bearish) and sometimes it will view the
distant situation as being more bullish (bearish). Asimilar behavioral pattern prevails in hogs.
thus,
the general rule would not apply in these types of markets.
in these markets, rather than being concerned about the overall price direction, the spread trader
is primarily concerned with how he thinks the market will perceive the fundamental situation in dif-
ferent time periods. For example, at agiven point in time, June cattle and
december cattle may be
trading at approximately equal levels. if the trader believes that marketings will become heavy in the
months preceding the June expiration, placing pressure on that contract, and further believes the
market psychology will view the situation as temporary, expecting prices to improve toward year-
end, he would initiate along
december/short June cattle spread. note that if he is correct in the
development of near-term pressure but the market expects even more pronounced weakness as time
goes on, the trade will not work even if his expectations for improved prices toward year-end also
prove accurate. One must always remember that aspread’slife span is limited to the expiration of the
nearer month, and substantiation of the spread idea after that point will be of no benefit to the trader.
thus, the trader is critically concerned, not only with the fundamentals themselves, but also with the
market’sperception of the fundamentals, which may or may not be the same.
 ■ Spread Rather Than Outright—An Example
Frequently, the volatility of agiven market may be so extreme that even aone-contract position may
represent excessive risk for some traders.
in such instances, spreads offer the trader an alternative
approach to the market. For example, in early 2014, coffee futures surged dramatically, gaining more
than 75 percent from late January to early March, with average daily price volatility more than tri-
pling during that period.
prices swung wildly for the next several months—pushing to ahigher high
in April, giving back more than half of the rally in the sell-off to the July low , and then rallying to yet
another new high in October (see Figure 30.1). At that juncture, assume alow-risk trader believed
that prevailing nearest futures prices near $2.22 in mid-October 2014 were unsustainable, but based
on the market’svolatility (which was still around three times what it had been early in the year) and his
money management rules felt he could not assume the risk of an outright position.
such atrader could
instead have entered abear spread (e.g., short July 2015 coffee/long december 2015 coffee) and
profited handsomely from the subsequent price slide. Figure 30.1 illustrates the close correspondence
between the spread and the market.
the fact that an outright position would have garnered amuch
larger profit is an irrelevant consideration, since the trader’srisk limitations would have prevented him
from participating in the bear move altogether had his market view been confined to outright trades.

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446A COMpLete guide tO tHe Futures MArKet
 ■ The Limited-Risk Spread
 the limited-risk spread is atype of intracommodity spread involving the buying of anear month
(relatively speaking) and the selling of amore distant month in astorable commodity in which the
process of taking delivery, storing, and redelivering at alater date does not require reinspection or
involve major transportation or storage complications. this defi nition would exclude such commodi-
ties as live cattle, which by defi nition are nonstorable, and sugar, which involves major complications
in taking delivery and storing. Commodities that fall into the limited-risk category include corn,
wheat, oats, soybeans, soybean oil, copper, cotton, orange juice, cocoa, and lumber.
2
 in acommodity fulfi lling the above specifi cations, the maximum premium that amore distant
month can command over anearby contract is roughly equal to the cost of taking delivery, holding
the commodity for the length of time between the two expirations, and then redelivering. the cost
for this entire operation is referred to as full carry. the term limited risk will be used only when the
nearby month is at adiscount. For example, assuming full carry in the October/december cotton
 FIGURE  30.1 July and december 2015 Coff ee Futures vs. July/december 2015 Coff ee spread
Chart created using tradestation. ©tradestation technologies, inc. All rights reserved.
 2 Although precious metals can easily be received in delivery, stored, and redelivered, they are not listed here
because spreads in precious metals are almost entirely determined by carrying charges. thus, the only motivation
for implementing an intramarket precious metals spread is an expectation for achange in carrying charges. in
contrast, the purpose of alimited-risk spread is to profi tfrom an expected narrowing of the spread relative to
the level implied by carrying charges (which are assumed to remain constant).

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tHe COnCepts And MeCHAniCs OF spreAd trAding
spread is equal to 200 points, along October/short december spread initiated at October 100 points
under might be termed alimited-risk spread. However, the same long October/short december
cotton spread would not be termed limited risk if, for example, October were at a 300-point pre-
mium. nevertheless, it should be noted that even in this latter case, the maximum risk would still be
defined—namely, 500 points—and in this respect the spread would still differ from spreads involving
the selling of the nearby contract, or spreads in markets that do not fulfill the limited-risk specifica-
tions detailed above.
the best way to understand why it is unlikely for the premium of adistant month to exceed car-
rying costs is to assume the existence of asituation where this is indeed the case. in such an instance,
atrader who bought anearby month and sold amore distant month would have an opportunity for
speculative gain and, at worst, would have the option of taking delivery, storing, and redelivering at
alikely profit (since we assumed asituation in which the premium of the distant month exceeded
carrying charges).
sounds too good to be true? Of course, and for this reason differences beyond full
carry are quite rare unless there are technical problems in the delivery process. in fact, it is usually
unlikely for aspread difference to even approach full carry since, as it does, the opportunity exists for
aspeculative trade that has very limited risk but, theoretically, no limit on upside potential.
in other
words, as spreads approach full carry, some traders will initiate long nearby/short forward spreads
with the idea that there is always the possibility of gain, but, at worst, the loss will be minimal. For
this reason, spreads will usually never reach full carry.
At asurface glance, limited-risk spreads seem to be highly attractive trades, and indeed they often
are. However, it should be emphasized that just because aspread is relatively near full carry does not neces-
sarily mean it is an attractive trade. Very often, such spreads will move still closer to full carry, resulting
in aloss, or trade sluggishly in anarrow range, tying up capital that could be used elsewhere. How-
ever, if the trader has reason to believe the nearby month should gain on the distant, the fact that the
spread has alimited risk (the difference between full carry and the current spread differential) makes
the trade particularly attractive.
the components of carrying costs include interest, storage, insurance, and commission. Wewill
not digress into the area of calculating carrying charges. ( such information can be obtained either
through the exchanges themselves or through commodity brokers or analysts specializing in the given
commodity.) However, we would emphasize that the various components of carrying charges are
variable rather than fixed, and consequently carrying charges can fluctuate quite widely over time.
interest
costs are usually the main component of carrying charges and are dependent on interest rates and
price levels, both of which are sometimes highly volatile.
it is critical to keep changes in carrying costs
in mind when making historical comparisons.
Can atrader ever lose more money in alimited-risk spread than the amount implied by the differ-
ence between full carry and the spread differential at which the trade was initiated? the answer is that
although such an occurrence is unlikely, it is possible. For one thing, as we indicated above, carrying
charges are variable, and it is possible for the theoretical maximum loss of aspread trade to increase
as aresult of fluctuations in carrying costs. For example, atrader might enter along October/short
december cotton spread at 100 points October under, at atime when full carry approximates 200
points—implying amaximum risk of 100 points. However, in ensuing months, it is possible higher

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A Complete Guide to the Futures mArket
prices and rising interest rates could cause full carry to move beyond 200 points, increasing the trad-
er’srisk correspondingly. in such an instance, it is theoretically possible for the given spread to move
significantly beyond the point the trader considered the maximum risk point. Although such an event
can occur, it should be emphasized that it is rather unusual, since in alimited-risk spread increased
carrying costs due to sharply higher price levels will usually imply larger gains for the nearby months.
As for interest rates, changes substantial enough to influence marked changes in carrying costs will
usually take time to develop.
Another example of alimited-risk spread that might contain hidden risk is the case in which
the government imposes price ceilings on nearby contracts but not on the more distant contracts.
Although highly unusual, this situation has happened before and represents apossible risk that the
spread trader should consider in the unlikely event that the prevailing political environment is condu-
cive to the enactment of price controls.
Also, for short intervals of time, spread differences may well exceed full carry due to the absence
of price limits on the nearby contract. For anumber of commodities, price limits on the nearby
contract are removed at some point before its expiration (e.g., first notice day, first trading day of
the expiring month, etc.). Consequently, in asharply declining market, the nearby month can move
to adiscount exceeding full carry as the forward month is contained by price limits. Although this
situation will usually correct itself within afew days, in the interim, it can generate asubstantial mar-
gin call for the spread trader.
it is important that spread traders holding their positions beyond the
removal of price limits on the nearby contract are sufficiently capitalized to easily handle such possible
temporary spread aberrations.
As afinal word, it should be emphasized that although there is atheoretical limit on the premium that
adistant month can command over anearby contract in carrying-charge markets, there is no similar limit on the
premium that anearby position can command.
nearby premiums are usually indicative of atight current
supply situation, and there is no way of determining an upper limit to the premium the market will
place on more immediately available supplies.
 ■ The Spread Trade—Analysis and Approach
Step 1: Straightforward historical Comparison
Alogical starting point is asurvey of the price action of the given spread during recent years. Histori-
cal spread charts, if available, are ideal for this purpose. if charts (or historical price data that can be
downloaded into aspreadsheet) are unavailable, the trader should, if possible, scan historical price
data, checking the difference of the given spread on abiweekly or monthly basis for at least the past
5 to 10 years.
this can prove to be atime-consuming endeavor, but aspread trade initiated without
any concept of historical patterns is, in asense, ashot in the dark. Although spreads can deviate
widely from historical patterns, it is still important to know the normal range of aspread, as well as
its “average” level.

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tHe COnCepts And MeCHAniCs OF spreAd trAding
Step 2: Isolation of Similar Periods
As arule, spreads will tend to act similarly in similar situations. thus, the next step would be arefine-
ment of step 1 by means of isolating roughly similar periods. For example, in ahigh-priced year, we
might be interested in considering the spread action only in other past bull seasons, or we can cut the
line still sharper and consider only bull seasons that were demand oriented or only those that were
supply oriented. An examination of the spread’sbehavior during different fundamental conditions in
past years will usually reveal the relative comparative importance of similar and dissimilar seasons.
Step 3: analysis of Spread Seasonality
this step is afurther refinement of step 1. sometimes aspread will tend to display adistinct seasonal
pattern. For example, agiven spread may tend to widen or narrow during aspecific period. Knowledge
of such aseasonality can be critically important in deciding whether or not to initiate agiven spread.
For example, if in nine of the past 10 seasons the near month of agiven spread lost ground to the distant
month during the March–June period, one should think twice about initiating abull spread in March.
Step 4: analysis and Implications of relevant Fundamentals
this step would require the formulation of aconcept of market direction (in commodities where
applicable), or equivalent appropriate analysis in those commodities where it is not. this approach is
fully detailed in the sections entitled “the general rule” and “the general rule—Applicability and
nonapplicability.”
Step 5: Chart analysis
Akey step before initiating aspread trade should be the examination of acurrent chart of the spread
(or the use of some other technical input). As in outright positions, charts are an invaluable informa-
tional tool and acritical aid to timing.
 ■ Pitfalls and Points of Caution
 ■ do not automatically assume aspread is necessarily alow-risk trade. in some instances, aspread
may even involve greater risk than an outright position. specifically, in the case of intercommodity
spreads, intercrop spreads, and spreads involving nonstorable commodities, the two legs of the
spread can sometimes move in opposite directions.
 ■ Be careful not to overtrade aspread because of its lower risks or margin. A 5- to 10-contract
spread position gone astray can often prove more costly than abad one-contract outright trade.
Overtrading is avery common error in spread trading.

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A Complete Guide to the Futures mArket
 ■ As ageneral rule, traders should avoid trading spreads in markets in which they are unfamiliar
with the fundamentals.
 ■ Check the open interest of the months involved to ensure adequate liquidity, especially in spreads
involving distant back months. Alack of liquidity can significantly increase the loss when getting
out of aspread that has gone awry. At times, of course, agiven spread may be sufficiently attrac-
tive despite its less-than-desirable liquidity.
nevertheless, even in such acase, it is important that
traders be aware of the extra risk involved.
 ■ place aspread order on aspread basis rather than as two separate outright orders. some traders
place their spread orders one leg at atime in the hopes of initiating their position at abetter price
than the prevailing market level.
such an approach is inadvisable not only because it will often
backfire, but also because it will increase commission costs.
 ■ When the two months of the spread are very close in price, extra care should be taken to specify
clearly which month is the premium month in the order.
 ■ do not assume that current price quotations accurately reflect actual spread differences. time lags
in the buying and selling of different contracts, as well as amomentary concentration of orders in
agiven contract month, can often result in outright price quotations implying totally unrepresen-
tative spread values.
 ■ do not liquidate spreads one leg at atime. Failing to liquidate the entire spread position at one
time is another common and costly error, which has caused many agood spread trade to end in
aloss.
 ■ Avoid spreads involving soon-to-expire contracts. expiring contracts, aside from usually being
free of any price limits, are subject to extremely wide and erratic price moves dependent on
technical delivery conditions.
 ■ do not assume the applicability of prior seasons’ carrying charges before initiating alimited-risk
spread. Wide price swings and sharply fluctuating interest costs can radically alter carrying costs.
 ■ try to keep informed of any changes in contract specifications, since such changes can substan-
tially alter the behavior of aspread.
 ■ properly implemented intercommodity and intermarket spreads often require an unequal num-
ber of contracts in each market. the methodology for determining the proper contract ratio be-
tween different markets is discussed in the next chapter.
 ■ do not use spreads to protect an outright position that has gone sour—that is, do not initiate an
opposite direction position in another contract as an alternative to liquidating alosing position.
in most cases such amove amounts to little more than fooling oneself and often can exacerbate
the loss.

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tHe COnCepts And MeCHAniCs OF spreAd trAding
 ■ Because it is especially easy to procrastinate in liquidating alosing spread position, the spread
trader needs to be particularly vigilant in adhering to risk management principals. it is advisable
that the spread trader determine amental stop point (usually on the basis of closing values) prior
to entering aspread and rigidly stick to liquidating the spread position if this mental stop point is
reached.
 ■ Avoid excessively low-risk spreads because transaction costs (slippage as well as commission) will
represent asignificant percentage of the profit potential, reducing the odds of anet winning out-
come.
in short, the odds are stacked against the very-low-risk spread trader.
 ■ As acorollary to the prior item, atrader should choose the most widely spaced intramarket
spread consistent with the desired risk level.
generally speaking, the wider the time duration in
an intramarket spread, the greater the volatility of the spread. this observation is as true for mar-
kets conforming to the general rule as for markets unrelated or inversely related to the general
rule.
traders implementing agreater-than-one-unit intramarket spread position should be sure to
choose the widest liquid spread consistent with the trading strategy. For example, it usually would
make little sense to implement atwo-unit March/May corn spread, since aone-unit March/July
corn spread would offer avery similar potential/risk trade at half the transaction cost.

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453
. . . many more people see than weigh.
—Philip Dormar Stanhope, Earl of Chesterfield
Bydefinition, the intention of the spread trader is to implement aposition that will reflect changes
in the price difference between contracts rather than changes in outright price levels. Toachieve
such atrade, the two legs of aspread must be equally weighted. As an obvious example, long 2
December corn/short 1 March corn is aspread in name only. Such aposition would be far more
dependent on fluctuations in the price level of corn than on changes in the price difference between
December and March.
The meaning of equally weighted, however, is by no means obvious. Many traders simply assume
that abalanced spread position implies an equal number of contracts long and short. Such an assump-
tion is usually valid for most intramarket spreads (although an exception will be discussed later in this
chapter). However, for many intermarket and intercommodity
1 spreads, the automatic presumption
of an equal number of contracts long and short can lead to severe distortions.
Consider the example of atrader who anticipates that demand for lower quality Robusta coffee
beans (London contract) will decline relative to higher quality Arabica beans (New York contract) and
Intercommodity
Spreads: Determining
Contract Ratios
Chapter 31
1 The distinction between intermarket and intercommodity spreads was defined in Chapter 30. An intermarket
spread involves buying and selling the same commodity at two different exchanges (e.g., New York vs. London
cocoa); the intercommodity spread involves buying and selling two different but related markets (e.g., wheat vs.
corn, cattle vs. hogs).

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A Complete Guide to the Futures mArket
attempts to capitalize on this forecast by initiating a 5-contract long New York coffee/short London
coffee spread. Assume the projection is correct, and London coffee prices decline from $0.80/lb to
$0.65/lb, while New York coffee prices simultaneously decline from $1.41/lb to $1.31/lb. At sur-
face glance, it might appear this trade is successful, since the trader is short London coffee (which has
declined by $0.15/lb) and long New York coffee (which has lost only $0.10/lb). However, the trade
actually loses money (even excluding commissions). The explanation lies in the fact that the contract
sizes for the New York and London coffee contracts are different: The size of the New York coffee
contract is 37,500 lb, while the size of the London coffee contract is 10 metric tonnes, or 22,043 lb.
(Note: In practice, the London coffee contract is quoted in dollars/tonne; the calculations in this sec-
tion reflect aconversion into $/pound for easier comparison with the New York coffee contract.)
Because of this disparity, an equal contract position really implies alarger commitment in New York
coffee. Consequently, such aspread position is biased toward gaining in bull coffee markets (assuming
the long position is in New York coffee) and losing in bear markets. The long New York/short London
spread position in our example actually loses $2,218 plus commissions, despite the larger decline in
London coffee prices:
Profit/los so fco ntractso funits per contrac tg ain/loss=× ×## per un it
Profit/loss in long New York coffee positio n5 37 5000=× ×−,( $. .) $,10/lb1 8 750=−
Profit/loss in short London coffee position = 52 20 43×× +,( $001 5/lb 16 532.) $,=+
Net profit/loss in sprea d2 218=− $,
The difference in contract size between the two markets could have been offset by adjusting the
contract ratio of the spread to equalize the long and short positions in terms of units (lb). The gen-
eral procedure would be to place U1/U2 contracts of the smaller-unit market (i.e., London coffee)
against each contract of the larger-unit contract (i.e., New York coffee). (U1 and U2 represent the
number of units per contract in the respective markets—U1 = 37,500 lb and U2 = 22,043 lb.) Thus,
in the New York coffee/London coffee spread, each New York coffee contract would be offset by
1.7 (37,500/22,043) London coffee contracts, implying aminimum equal-unit spread of five London
coffee versus three New York coffee (rounding down the theoretical 5.1-contract London coffee posi-
tion to 5 contracts.) This unit-equalized spread would have been profitable in the above example:
Profit/los so fco ntractso funits per contrac tg ain/loss=× ×## per un it
Profit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10/lb1 1 250=−
Profit/loss in short London coffee position 52 20 43 0=× ×+,( $. 115/lb +1 6 532)$ ,=
Net profit/loss in sprea d+ 5 282= $,
The unit-size adjustment, however, is not the end of our story. It can be argued that even the
equalized-unit New York coffee/London coffee spread is still unbalanced, since there is another signifi-
cant difference between the two markets: London coffee prices are lower than New York coffee prices.
This observation raises the question of whether it is more important to neutralize the spread against
equal price moves or equal-percentage price moves. The rationale for the latter approach is that, all
else being equal, the magnitude of price changes is likely to be greater in the higher-priced market.

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IntercommodIty SpreadS: determInIng contract ratIoS
The fact that percentage price change is amore meaningful measure than absolute price change is
perhaps best illustrated by considering the extreme example of the gold/silver spread. The equal-unit
approach, which neutralizes the spread against equal-dollar price changes in both markets, would
imply the rather ludicrous spread position of 50 gold contracts versus 1 silver contract. (The contract
size of silver is 5,000 oz; the contract size of gold is 100 oz.) Obviously, such aposition would be
almost entirely dependent upon changes in the price of gold rather than any movement in the gold/
silver spread. The disparity is due to the fact that since gold is far higher priced than silver (by aratio
of 32-101:1 based on the past 30-year range), its price swings will also be far greater. For example, if
gold is trading at $1,400/oz and silver at $20/oz, a $2 increase in silver prices is likely to be accom-
panied by far more than a $2 increase in gold prices. Clearly, the relevant criterion in the gold/silver
spread is that the position should be indifferent to equal percentage price changes rather than equal
absolute price changes. Although less obvious, the same principle would also appear preferable, even
for intercommodity or intermarket spreads between more closely priced markets (e.g., New York
coffee/London coffee).
Thus we adopt the definition that abalanced spread is aspread that is indifferent to equal percentage
price changes in both markets. It can be demonstrated this condition will be fulfilled if the spread is
initiated so the dollar values of the long and short positions are equal.
2 An equal-dollar-value spread
2 If the spread is implemented so that dollar values are equal, then:
NU PN UPtt11 10 22 20,,== =
where N1 = number of contracts in market 1
 N2 = number of contracts in market 2
 U1 = number of units per contract in market 1
 U2 = number of units per contract in market 2
 P1,t=0 = price of market 1 at spread initiation
 P2,t=0 = price of market 2 at spread initiation
An equal-percentage price change implies that both prices change by the same factor k. Thus,
Pk PP kPtt tt11 10 21 20,, ,,== ==== and
where Pl,t = 1 = price of market 1 after equal-percentage price move
 P2,t = 1 = price of market 2 after equal-percentage price move
And the equity changes (in absolute terms) are:
Equity change in market 1 positio n =− ===NU kP PN UPtt11 10 10 11 1|| ,, ,tttt
k
NU kP P
=
==
−
=−
0
22 20 20
1 |
| ,,
|
Equity change in market 2 positio n| || ,=− =NU Pkt22 20 1 |
Since, by definition, an equal-dollar-value spread at initiation implies that N1U1P1,t = 0 = N2U2P2,t = 0, the equity
changes in the positions are equal.
It should be noted that the equal-dollar-value spread only assures that equal-percentage price changes will
not affect the spread if the percentage price changes are measured relative to the initiation price levels. However,
equal-percentage price changes from subsequent price levels will normally result in different absolute dollar
changes in the long and short positions (since the position values are not necessarily equal at any post-initiation
points of reference).

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