e 2. It is a good idea to start by analyzing and following only one or two
markets fundamentally, expanding this list only after all research ideas on previously chosen markets
have been investigated. The third alternative is a reasonable supplement to individual research, as long
as one is selective. Unfortunately, a significant portion of published research is analytically unsound.
However, if you have fully grasped the concepts of this section, you should have no difficulty in evalu-
ating the analytic merit of available published research.
Once a market has been selected for fundamental study, the following step-by-step approach can
be employed:
 1. read background material. The first step in any analysis must be a familiarization with the
given market. Before beginning, an analyst must have a good idea of the key fundamentals that
affect the market, as well as the primary sources of statistical information.
 2. Gather statistics. Once you have a good understanding of the basic mechanics of a market,
list all the statistics that might be relevant in formulating a price analysis. The U.S. Department
of Agriculture (USDA), which publishes a wide variety of reports on domestic and foreign agri-
cultural products, is an excellent source of information. Another major source of statistics is the
CRB Commodity
 Yearbook, which contains extensive data for the complete range of commodity
markets. For many markets, special statistical sources will have to be consulted. The familiariza-
tion process described in step 1 should provide the information regarding the primary statistical
sources for a given market.
 3. adjust price data for inflation. This adjustment is an essential step in fundamental price
forecasting. As a caveat, though, if there is a prevailing downward-shifting trend in demand
(a circumstance that will offset inflation), then unadjusted prices could yield more accurate
forecasts.
 4. Construct a model. Select one or more of the approaches discussed in Chapter 23 and
attempt to construct a price-explanatory model. Regression analysis, which is perhaps the most
powerful and efficient of these approaches, is covered comprehensively in the Appendices.
 5. Modify model. After identifying which past years, or seasons, failed to fit the general pattern,
try to determine the factors that were responsible for the aberrant behavior. Attempt to incor-
porate these factors into the general model. In some cases, highly unusual price action in a past
year might reflect the impact of isolated events (e.g., price controls, export embargoes, forced
liquidation by huge speculators) that are not relevant to the current market. In such situations,
it is often preferable to delete the abnormal year from the model. It should be emphasized, how-
ever, that the expedient deletion of a year simply because it does not fit the pattern constitutes
improper methodology. The practical decision-making process in the deletion of years from a
model is discussed in much greater detail in Appendix E.
 6. Incorporate expectations. Check to see whether expectation-based statistics improve the
model.
415
Building a Forecasting Model: a step-By -step approach
 7. estimate the independent variables. The independent variables are the factors used to
explain and forecast prices in the model. These inputs must be estimated for the forecast period.
For example, the coming season's corn crop, which would obviously be a key input in any corn
price-forecasting model, could be estimated on the basis of planting intentions, historical yields,
and weather conditions to date.
 8. Forecast a price range. Allowing for a plausible range of values for each of the independent
variables, use the model to forecast a price range for the upcoming period.
 9. evaluate the potential impact of government regulations. Consider whether existing
government programs or international agreements are likely to interfere with the normal free
market mechanism.
 10. examine seasonal patterns. Using the methods discussed in Chapter 26, determine whether
there are any pronounced seasonal patterns for the given market. Furthermore, it is essential
to check whether recent price action has violated normal seasonal patterns, since such behavior
might reflect underlying weakness or strength.
 11. Search for market response patterns. As detailed in Chapter 27, a market response to
key fundamental information (e.g., major government reports) might provide important clues
regarding the impending price direction.
 12. assess the trade opportunity. Compare the potential price range implied by the forego-
ing analytic steps with the prevailing price level. A trading opportunity is only indicated if the
current price is outside the projected range. (This step will not be applicable for analytical
approaches designed to forecast the direction of the market rather than the price level.)
 13. time trade entry. Some elements of the fundamental approach, such as seasonal analysis and
market response patterns, and some fundamental methods, such as index models, might pro-
vide timing clues. Generally speaking, however, the timing of a trade entry should be based on
technical input (e.g., chart analysis, technical model). Otherwise, the timing of fundamentally
oriented trades is apt to be based on the date on which the analysis is completed—a ludicrous
proposition. Furthermore, it should be emphasized that even if the fundamental analysis is cor-
rect, prices can always get more out of line before the trend is reversed. The practical aspects of
combining fundamental analysis and trading are the subject of Chapter 29.

417
Chapter 29
Fundamental
Analysis and Trading
All our knowledge brings us nearer to our ignorance.
—T . S. Eliot
 ■ Fundamental versus Technical Analysis:
A Greater Need for Caution
Virtually every market student who has ever relied on fundamental analysis as the basis of a market
opinion can recall instanc


aspects of
combining fundamental analysis and trading are the subject of Chapter 29.

417
Chapter 29
Fundamental
Analysis and Trading
All our knowledge brings us nearer to our ignorance.
—T . S. Eliot
 ■ Fundamental versus Technical Analysis:
A Greater Need for Caution
Virtually every market student who has ever relied on fundamental analysis as the basis of a market
opinion can recall instances in which his conclusions proved dead wrong. The same, of course, can be
said for the technical analyst. However, there is a critical distinction between them. If the technical
analyst’s methodology leads to erroneous projections, the same analytic tools will eventually point
to an opposite conclusion. In effect, technical analysis is a self-correcting approach. In contrast, the
fundamental analyst treads on far more dangerous ground. If the fundamental analyst’s assessment
indicates wheat prices should be $7.00 when the market price is $6.00, by definition, he would be
even more bullish if prices were to decline to $5.50—assuming the key economic statistics have
remained unchanged.
Therein lies the great danger in using fundamental analysis: The more inaccurate the projection,
the more adamant practitioners are apt to become regarding the current attractiveness of market
positions in line with their original prognostications. Thus, traders who base their decisions strictly
on fundamental considerations might find themselves pyramiding positions in those situations they
are most incorrect—a blueprint for disaster. In other words, there is a real danger that a sole or near-
exclusive reliance on fundamentals will sooner or later transform an error into a major trading loss.
418
A Complete Guide to the Futures mArket
In fact, this very experience has caused many fundamentalists to renounce their former analytic
beliefs. One is reminded of Mark Twain’s observation: “The cat that sits down on a hot stove lid will
never sit down on a hot stove lid again . . . [nor on] a cold one.” The problem lies not in the validity
of fundamental analysis as a valuable analytic tool, but rather in the failure to recognize the limitations
of this approach. This chapter focuses on these limitations.
 ■ Three Major Pitfalls in Fundamental Analysis
Even fundamental analysts who do everything right will eventually find themselves reaching the
wrong conclusion. There are three possible reasons this could occur:
1.
the unexpected development. In this case, the model is right, but the assumptions are
wrong. The 1972–1973 cotton market provides a classic historical example of such a development.
Before that time, the United States did not export any cotton to China. This situation changed dra-
matically during the 1972–1973 season, when the United States exported more than one-half million
bales, or approximately 11 percent of its total shipments, to the People’s Republic of China (PRC).
Table 29.1 shows exports to the PRC further expanded in the 1973–1974 season. The sudden emer-
gence of the PRC as a major importer of U.S. cotton was one of the key factors behind the historic
1972–1973 bull market in cotton.
W eather often plays the role of the unexpected development in agricultural markets. Figure 29.1
depicts the price impact of the 1989 freeze on the frozen concentrated orange juice (FCOJ) market.
Figure 29.2 illustrates the price impact of the 2012 drought on the corn market. Although such devel-
opments in the weather are hardly extraordinary, they cannot be anticipated, since allowing for their
possible occurrence would lead to inflated price projections in most other years.
An example of an impossible-to-predict sequence of events causing a major market reaction was
the March 2011 Japanese earthquake, which triggered a tsunami that caused core meltdowns in three
of the Fukushima Daiichi nuclear reactors. (Although the possibility that a tsunami could result in a
major accident was anticipated by some, the timing of such a tsunami was, of course, unpredictable.)
Figure 29.3 shows this disaster resulted in a 20 percent plunge in the Nikkei index futures over the
course of four days.
table 29.1 early 1970s Shift in U.S. Cotton exports to the people’s republic of China (1,000 bales)
Season exports to prC total exports exports to prC as percentage of total
1971–1972 0 3,385 0
1972–1973 585 5,311 11.0
1973–1974 898 6,123 14.7
1974–1975 307 3,926 7.8
1975–1976 9 3,311 0.2
1976–1977 0 4,784 0
419
FUNDAMENTAl ANAlySIS AND TRADINg
 FIGURE  29.1 March 1990 FCOJ
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  29.2 September 2012 Corn
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

420A COMPlETE gUIDE TO THE FUTURES MARKET
 FIGURE  29.3 Nikkei 225 Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 Iraq’s August 1990 invasion of Kuwait is another example of how an unanticipated event can dra-
matically alter the supply-demand balance and trigger a huge price shift. As depicted in Figure 29.4 ,
this event was followed by a huge advance in crude oil prices, as the market’s perceptions about avail-
able oil supplies shifted in response to interrupted Kuwaiti output, the embargo against Iraqi crude,
and fears that the confl ict would extend to threaten critical Saudi Arabian supplies.
 Figure 29.5 shows the dramatic impact of the unexpected decision by Switzerland’s central bank
to remove a price cap on the Swiss franc that had been in place for approximately three years. This
shock event caused an almost immediate 25 percent leap in the Swiss franc’s value on January 15,
2015. Although this price surge was largely reversed over the subsequent two months, the sudden
market move had a devastating impact on currency traders with short positions in the Swiss franc.
 Surprises in government reports, which can trigger sharp price reactions, are a c

eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf


tely three years. This
shock event caused an almost immediate 25 percent leap in the Swiss franc’s value on January 15,
2015. Although this price surge was largely reversed over the subsequent two months, the sudden
market move had a devastating impact on currency traders with short positions in the Swiss franc.
 Surprises in government reports, which can trigger sharp price reactions, are a common source
of unexpected developments. However, because the release dates of these reports are known, as
are the reports that are apt to cause large price moves (typically, the initial planting and production
estimates in agricultural markets), the resulting price moves are not completely unexpected in the
way an unscheduled event might be (e.g., freeze, nuclear accident, invasion). Sometimes, however, a
report that does not typically trigger a major price impact may do so. One such instance was the U.S.
Department of Agriculture’s (USDA) quarterly corn stocks report released on March 28, 2013. Dur-
ing what was perceived to be an exceptionally tight corn market (as a result of the drought referenced
by Figure 29.2 ), the report indicated corn stocks were nearly 8 percent (387 million bushels) higher
than previously estimated. In response, corn futures dropped more than 5 percent the next trading
day, and more than 8 percent the day after that (see Figure 29.6 ).
421
FUNDAMENTAl ANAlySIS AND TRADINg
 FIGURE  29.4 December 1990 WTI Crude Oil
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  29.5 Swiss Franc Continuous Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

422A COMPlETE gUIDE TO THE FUTURES MARKET
 FIGURE  29.6 May 2013 Corn
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 2. the missing variable. Quite often, a market whose price behavior has been adequately
described by a set of variables for an extended period of time will suddenly be dramatically aff ected
by an entirely new factor. The 1972–1973 infl ationary boom, and its associated hoarding psychology,
provides an excellent example of a missing key factor. During this period, price behavior in diff erent
markets became far more interdependent, and a wide variety of markets far exceeded the price levels
suggested by their intrinsic fundamentals. Any fundamental analysis of a specifi c market that failed to
take into account the potential price impact of the overall bullish wave would have yielded sharply
understated price projections.
 The 1981–1982 period provided an almost exact opposite example of a missing key variable. In
this instance, failure to take into account the pronounced impact of simultaneous defl ation and high
real interest rates on inventory psychology would have resulted in overstated price forecasts for virtu-
ally any commodity market.
 It is tempting to think that pivotal events such as the two aforementioned major shifts in com-
modity demand curves were so readily apparent they would have been quickly incorporated into any
fundamental model. Such major transitions, however, tend to be far more conspicuous in retrospect
than at the time of their occurrence. Often by the time such structural changes become evident,
prices have already witnessed a major move.
 3. poor timing. Even if fundamental analysis is accurate and the assumptions are correct, a mar-
ket can still move counter to the fundamental price projection over the short term—or even the
intermediate term. In other words, generally speaking, fundamental models do not provide reliable
timing information.
423
FUNDAMENTAl ANAlySIS AND TRADINg
 FIGURE  29.7 Case-Shiller National Home Price Index, Infl ation Adjusted
Source: www .econ.yale.edu/~shiller/data.htm. Data refl ect December values for each calendar year.
 Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 The 2008 fi nancial meltdown and the subsequent great Recession provide an excellent illustra-
tion of the disconnect between changes in the fundamentals and the timing of price moves. There
were many reasons for the 2008 fi nancial crisis but certainly chief among them was the bursting of
the housing bubble that had seen housing prices far exceed historical norms. For more than a century
since the starting year of the Case-Shiller Home Price Index, the infl ation-adjusted index level fl uctu-
ated in a range of approximately 65 to 130. At the peak of the 2003–2006 housing bubble, the index
had nearly doubled its long-term median level (see Figure 29.7 ).
 The extremes of the housing bubble were fueled by excesses in subprime mortgage lending: loans
were made to borrowers with poor credit, requiring little or no money down, and in its later phases no
verifi cation of income or assets. An insatiable demand for mortgages to bundle into mortgage-backed
securities (MBSs) incentivized mortgage lenders to write as many mortgages as possible. These lenders
were unconcerned about whether borrowers could pay back the loans because they passed on the owner-
ship of mortgages to other fi nancial institutions for use in securitizations. The competition among mort-
gage lenders to fi nd new borrowers seemed like a race to issue the poorest quality mortgages possible.
 The S&P Case-Shiller Home Price Index peaked in the spring of 2006 (see Figure 29.8 ).
At the same time, the rate of delinquencies on subprime adjusted rate mortgages (ARMs) rose
steadily throughout 2006 and accelerated in 2007 (see Figure 29.9 ). Despite these ominous
developments, U.S. stock prices continued to move higher, ultimately extending to new record
levels, as shown in Figures 29.8 and 29.9 . In fact, the extension of the equity bull market after
the peak in housing prices in mid-2006 occurred in the face of a more than doubling of sub-
424A COMPlETE gUIDE TO THE FUTURES MARKET
 FIGURE  29.8 The S&P/Case-Shil


ee Figure 29.9 ). Despite these ominous
developments, U.S. stock prices continued to move higher, ultimately extending to new record
levels, as shown in Figures 29.8 and 29.9 . In fact, the extension of the equity bull market after
the peak in housing prices in mid-2006 occurred in the face of a more than doubling of sub-
424A COMPlETE gUIDE TO THE FUTURES MARKET
 FIGURE  29.8 The S&P/Case-Shiller Home Price Index (20-City Composite, Seasonally
Adjusted) vs. S&P 500 Index Median Monthly Price
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 FIGURE  29.9 Subprime Arm T otal Delinquencies vs. S&P 500 Median Monthly Price
Source: OTS (delinquency data)
 Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

425
FUNDAMENTAl ANAlySIS AND TRADINg
prime delinquencies—a fundamental development that not only had very negative implications
for housing prices and the economy, but also seriously imperiled the literally trillions of dol -
lars of subprime MBS that had been issued. All these factors were bearish for the stock market.
Nonetheless, it was not until 18 months after housing prices had peaked and a similar interim
of sharply rising delinquencies on subprime mortgages that the stock market finally topped out
in October 2007.
Assume a fundamental analyst came to the conclusion the prevailing bull market in equities during
the mid-2000s was critically dependent on an ongoing housing bubble, which could not be sustained,
and whose inevitable reversal would lead to a stock market collapse—a prognostication that would
ultimately prove spectacularly correct. Further assume this analyst interpreted the reversal in the
Case-Shiller Home Price Index in mid-2006 and the concurrent emerging uptrend in subprime mort-
gage delinquencies as early evidence that the housing bubble was unraveling—another correct assess-
ment. Now consider the outcome if the analyst acted on this market assessment by implementing a
short position in stock index futures in September 2006—the month after subprime delinquencies
reached a new multiyear high. A short S&P position initiated at the median price in September 2006
would have been exposed to a 20 percent rise in the index before the stock market ultimately peaked
in October 2007. Although the stock market subsequently collapsed, it is highly unlikely the analyst
could have survived such a large adverse price move before giving up and liquidating the position at
a large loss.
The point is not that fundamentally oriented traders should adamantly hold on to positions if they
have a strong conviction in their market analysis—a mental attitude that would be almost certain to
result in financial ruin, as it would take only one wrong forecast to lead to a devastating loss. Rather,
the point is that even accurate fundamental analysis can lead to poor trading results if fundamentals are
used for timing.
Crude oil prices in 1985 offer another classic example of a market that continued to extend its
prior trend after an important fundamental change, only to witness a belated major reversal many
months later. In March 1985 the Saudis announced they would no longer be the Organization of the
Petroleum Exporting Countries’ (OPEC) “swing supplier” (i.e., the producer that adjusted its output
to keep supply and demand in balance). Their decision to abandon their price-supportive role had
bearish implications. The Saudis implemented this policy by introducing netback crude oil pricing
during the summer of 1985, or guaranteeing buyers of Saudi oil a profit margin. In essence, the Sau-
dis were pricing their oil at whatever price was necessary to move all their production. Despite this
ominous action, prices still continued to climb (see Figure 29.10). Prices did not collapse until OPEC
officially decided to “pursue market share” at their December 1985 meeting, six months after the de
facto implementation of such a policy by Saudi Arabia.
A fundamental analyst who decided in the summer of 1985 that the world oil market was vulner-
able to a collapse would have been absolutely right—eventually. In the interim, any short positions
implemented on this analysis would have been subject to a protracted, large loss. Thus, poor timing
of trade entry based on the timing of fundamental events could have transformed a potential windfall
trade into a major loss. The simple fact is that the timing of price moves is often out of sync with the
timing of fundamental developments.
426A COMPlETE gUIDE TO THE FUTURES MARKET
 FIGURE  29.10 March 1986 WTI Crude Oil Futures
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 ■ Combining Fundamental Analysis with Technical
Analysis and Money Management
 As a result of the three pitfalls in fundamental analysis, a buy-and-hold or sell-and-hold trading strat-
egy will eventually prove disastrous for virtually any fundamental analyst. Even assuming a price-
forecasting model always managed to include all key variables, a fundamental analyst would still
be vulnerable to large trading losses as a result of unexpected developments and poor timing. The
observations in the previous section suggest the following important trading rule:
rUle: Never hold a fundamental opinion with complete rigidity.
 Clearly, fundamental analysis alone is insuffi cient for making trading decisions. The two missing
ingredients are technical analysis and money management. These various inputs can be combined in
the following manner. Fundamental analysis is used as the initial step in the decision-making process
in order to determine whether the market is underpriced, overpriced, or in line.
rUle: View fundamental analysis as a tool for gauging whether the market is out of line.
 Once a fundamental indication is obtained, technical factors are checked for possible confi rma-
tion. This technical input can be in the form of charts


ental analysis is used as the initial step in the decision-making process
in order to determine whether the market is underpriced, overpriced, or in line.
rUle: View fundamental analysis as a tool for gauging whether the market is out of line.
 Once a fundamental indication is obtained, technical factors are checked for possible confi rma-
tion. This technical input can be in the form of charts or a mechanical system. The main point is that
it is necessary to check whether the fundamentally suggested trade appears reasonable in terms of
market action. For example, if fundamentals suggest the market is overpriced at a time when prices
427
FUNDAMENTAl ANAlySIS AND TRADINg
are in an unbroken uptrend, it would usually be best to delay the implementation of any short posi-
tion. However, such a fundamental projection might still provide the motivation for initiating shorts
on the first signs the market is faltering.
Occasionally, it is reasonable to implement a fundamental trade counter to the prevailing price
trend if the market is approaching a major resistance area. For example, assume corn prices are cur-
rently $6/bushel and in a virtually unbroken uptrend, while fundamental analysis suggests an equi-
librium price level of only $5. If the market is approaching a major resistance area (e.g., a previous
high, or the low end of a prior trading range), one might use fundamental analysis as the justification
for anticipating a top. However, the trade should only be considered if the trader chooses a predeter-
mined exit point.
This point introduces the third major element in making trading decisions: money management.
Of course, the control of losses is essential even when the trading implications of fundamental and
technical analysis are in full agreement. However, money management is particularly critical when
one is anticipating a market turn.
rUle: An effective trading approach should combine fundamental analysis with technical analysis
and money management.
 ■ Why Bother with Fundamentals?
At this point, the reader might well ask: If fundamental input must be used in conjunction with tech-
nical analysis, why should the trader even bother with fundamental analysis in the first place? There
are several answers to this question:
 1. Fundamental analysis provides an extra dimension of information not available to the purely tech-
nical trader. Knowing why a market is acting the way it is can be invaluable in trading decisions.
For example, a rally in a declining market might be attributable to a news item that does not
meaningfully alter a bearish fundamental outlook, or it might reflect that the market is oversold
relative to the fundamentals. T echnical analysts cannot distinguish between these two situations—
they must treat all similar patterns alike, regardless of the underlying causes. The fundamental
analyst, however, can use an awareness of existing market conditions and potential developments
as an aid in assessing whether a rally is likely to be the beginning of a new bull market or a bull
trap. Of course, such value judgments will not always be accurate, but this consideration is not a
problem. For fundamental input to be of value, it is only necessary that profits (or reduced losses)
tied to correct decisions exceed the losses (or reduced gains) resulting from incorrect decisions.
 2. Fundamentals might sometimes portend a major price move well in advance of any technical
signals. The trader who is aware of such a potential transition could have an important advantage
over traders who are only following technical signals.
 3. A knowledge of fundamentals would permit a trader to adopt a more aggressive stance when
the fundamentals suggest the potential for a major move. The strictly technical trader, however,
would have to treat all trading signals the same.
428
A Complete Guide to the Futures mArket
 4. An understanding of the underlying fundamentals can provide the incentive to stay with a win-
ning trade.
 5. The way in which a market responds to fundamental news can be used as a trading tool, even by
the technical trader.
 ■ Are Fundamentals Instantaneously Discounted?
One aspect of the efficient market hypothesis, a popular theory subscribed to by many economists,
can be paraphrased as follows: At any given time, the market discounts all known information. Of
course, if this premise were true, all market analysts—and readers of this book as well—would
be suffering from mass delusion. However, there are more compelling reasons for contesting this
hypothesis. One reason is the fundamental information responsible for a major price transition is
frequently available well before the price trend actually develops. Another reason is that price moves
often reflect a reaction to a preceding price swing that had carried the market well beyond funda -
mentally sustainable equilibrium levels. In both cases, dramatic price moves may materialize in the
apparent absence of any significant concurrent change in the basic fundamentals. In fact, in the case
in which a market has sharply overshot its equilibrium level, it is not unusual for prices to respond
in the opposite direction one would anticipate for certain fundamental news (e.g., a rally following
a bearish news item).
The aforementioned types of price behavior are inexplicable only if one assumes the market dis-
counts all known information at any given time. However, a far more plausible view of market behav-
ior is that prices sometimes lag or anticipate the levels implied by existing information.
Copper during 2002 through 2006 provides a good example of a market in which price moves
occurred well after the fundamental changes responsible for those moves. In 2002, copper invento-
ries reached enormous levels. Not surprisingly, the copper market languished at low prices. Inven-
tories then embarked upon a long decline, but prices failed to respond for more than a year (see
Figure 29.11). Beg


per during 2002 through 2006 provides a good example of a market in which price moves
occurred well after the fundamental changes responsible for those moves. In 2002, copper invento-
ries reached enormous levels. Not surprisingly, the copper market languished at low prices. Inven-
tories then embarked upon a long decline, but prices failed to respond for more than a year (see
Figure 29.11). Beginning in late 2003, prices finally adjusted upward to a higher plateau, as invento-
ries continued to slide. Prices then continued to move sideways at this higher level for about one year
(early 2004 to early 2005), even though inventories fell still further. This sideways drift was followed
by an explosive rally, which saw prices nearly triple in just over one year’s time. Ironically, this enor-
mous price advance occurred at a time when inventories had actually begun to increase moderately.
A fundamental analyst who correctly anticipated both the peak and low in copper inventories and
traded based on the timing of shifting fundamentals could well have fared poorly.
Price responses followed major changes in the fundamentals (inventory levels) with long lags.
The market in 2006 traded at dramatically higher price levels on the same fundamentals as it did in
early 2005. These long lags between changes in fundamentals and price adjustments contradict the
immediate price adjustments implied by the efficient market hypothesis. The more plausible explana-
tion is that the shift in market psychology from complacency regarding ample supply availability to
heightened sensitivity over supply shortages occurred gradually over time rather than as an immediate
response to changing fundamentals.
429
FUNDAMENTAl ANAlySIS AND TRADINg
 FIGURE  29.11 lME Copper Inventories vs. lME Copper Prices
CQg, Inc. ©
979030
24232
950000
900000
850000
800000
750000
700000
650000
600000
550000
550000
450000
400000
350000
300000
250000
200000
150000
100000
2002
Jan Jul
50000
411425
2003
Jan Jul
2004
Jan Jul
2005
Jan
2006
JanJul
7170
8500
8000
7500
7000
6500
6000
5500
5000
4500
4000
3500
3000
2500
2000
1500
2002
Jan Jul
2003
Jan Jul
2004
Jan Jul
2005
Jan
2006
JanJul
O= 411425 Line
E= −2375
L= 411425
I= 411425
H= 411425
430A COMPlETE gUIDE TO THE FUTURES MARKET
 FIGURE  29.12 March 1986 Corn
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.
 The 1985–1986 corn market provides another excellent illustration of the nonsynchronous rela-
tionship between fundamental information and price movements. Corn prices rose steadily from
September through December 1985 (see Figure 29.12 ), despite repeated increases in the production
estimate and reductions in the total usage projection, which resulted in a consistent expansion in the
forecasted ending stock/usage ratio (see Table 29.2 ). This price action would be completely inexpli-
cable if one assumed that prices always responded instantaneously to new fundamental information,
a popular academic premise that is subject to frequent empirical contradiction in the real world.
Rather, it makes far more sense to view the subsequent price collapse in January/February 1986 as a
belated response to the steady deterioration in the fundamental picture in late 1985.
 table 29.2 Corn: USDa Supply/Disappearance estimates During 1985–1986 Season (million bushels)
Month production total Use ending Stocks Stock/Use ratio (%)
August 1985 8,266 7,145 2,364 33.1
September 1985 8,469 7,070 2,717 38.4
October 1985 8,603 7,070 2,851 40.3
November 1985 8,717 7,045 3,052 43.3
December 1985 8,717 7,045 3,052 43.3
January 1986 8,717 7,045 3,052 43.3
February 1986 8,865 6,845 3,403 49.7
431
FUNDAMENTAl ANAlySIS AND TRADINg
 ■ Fitting the News to Price Moves
Although day-to-day price moves often reflect ongoing adjustments to background fundamentals
and shifting expectations rather than reactions to concurrent events, the media will usually seek to
fit the news to market price movements. If the market is up sharply on a given day, some economic
news will be found to explain the price strength. Similarly, if the market breaks precipitously, it’s a
safe bet that some bearish fundamental explanation will be found. This tailoring of news to fit the
price action can sometimes reach absurd lengths, as exemplified by the following two excerpts.
The first selection is from an article with the headline, “Strong Economic Reports
give a lift to
the Dollar”:
The dollar closed mostly higher yesterday after what currency traders saw as stronger-
than-expected economic reports. “There was good reaction to surprisingly strong num-
bers,” said . . . “The biggest one was retail sales.” . . . The Commerce Department reported
that retail sales rose three-tenths of 1 percent in November, after remaining unchanged in
October. A fall in new weekly claims for unemployment also helped the dollar.
The next quotation comes from a story with the headline, “
long- T erm Rates Fall on Reports”:
. . . bond prices benefited from a Commerce Department report that showed the
Christmas buying season got off to a slow start in November. . . . At first blush, the
numbers seemed to suggest that consumer activity had begun to pick up. But analysts
said the increase was tainted because of the downward revisions in sales figures for Sep-
tember and October. “The revisions showed that consumers are still struggling,” said . . .
Both of these stories come from the same newspaper, on the same day, on facing pages!
Of course, major unexpected developments will have an immediate market impact when they
become known, but for the most part, the efficient market hypothesis assumption that prices instan-
taneously adjust to fundamental news has it exactly backwards. It is far more accurate to say the
financial news will instantaneously adjust to price changes. Whether the market is up or down on a
given day, financial reporters have to find an explanation for the price move. Therefore, an


n they
become known, but for the most part, the efficient market hypothesis assumption that prices instan-
taneously adjust to fundamental news has it exactly backwards. It is far more accurate to say the
financial news will instantaneously adjust to price changes. Whether the market is up or down on a
given day, financial reporters have to find an explanation for the price move. Therefore, an explana-
tion will be drawn from the coincident news developments on that day, whether they are pertinent
or not. This routine process can lead to the comical situation of the same development being used
as both a bullish and bearish explanation on days where the market traverses widely between up and
down or vice versa.
August 26, 2011, was a perfect example. On that day, the market sold off in the morning, and then
rallied sharply into the afternoon. The key focus of market attention was a speech by Federal Reserve
Chairman Ben Bernanke. The following two headlines announced stock market news stories issued by
the same newswire service on the same day:
Wall Street Slides after Bernanke Comments
Wall Street Bounces as Bernanke Keeps Hopes Alive
432
A Complete Guide to the Futures mArket
The first story read, “Major indexes fell more than 1 percent after Federal Reserve Chairman
Ben Bernanke said the U.S. economic recovery was much less robust than hoped but stopped short
of signaling further action to boost growth.” The second story saw things a bit differently: “Bernanke
raised hope the Fed could consider further stimulus measures for the economy at an extended policy
meeting in September.”
Now , you could believe the same event was bearish before it was bullish. It seems considerably
more plausible, though, to believe that the interpretation of the event was altered to fit the market
price action. I can assure you that if the market had failed to rebound, there would not have been any
stories about how the market ignored Bernanke’s constructive comments. The market action deter-
mines the interpretation of the news, not the other way around.
Quite frequently prices move higher on the same longer-term fundamentals that have been known
for some time or in reaction to a prior decline that took prices too low based on the underlying funda-
mentals. But while these types of longer-term underlying factors are what really move prices, rather
than the often minor or irrelevant developments that are coincident on the same day, they apparently
do not make acceptable news copy. When was the last time you saw a financial page headline that
read, “Market Rallies Sharply because Bullish Fundamentals Unchanged” or “Market Plunges as Prices
Correct Recent Speculative Mania”?
 ■ Fundamental Developments: Long-Term Implications
versus Short-Term Response
In interpreting new developments, it is necessary to make a distinction between the long term and
the short term. The long-term interpretation is fairly straightforward: All else being equal, a bullish
news item suggests higher prices. However, the short-term interpretation of new developments is
entirely different: The essential consideration is how the market responds to the news. In this regard,
as summarized by the following rule, the significant occurrence is a divergence between fundamental
news and subsequent price action.
rUle: A bullish fundamental development that is followed by a decline or that prompts a rally
well below expectations should be viewed as a bearish signal. A bearish fundamental development
that is followed by a rally or that prompts a significantly smaller-than-anticipated decline should
be viewed as a bullish signal.
By no means is this rule sufficient by itself to allow trading decisions. But in conjunction with
other market information, such as background fundamentals and the technical picture, an awareness
of this rule should help improve a trader’s performance.
Some examples of interpreting market response were provided in Chapter 27. Still, another
example might help clarify this approach in using fundamental developments as a trading tool. The
time was December 24, 1980, and the cotton market finished the holiday-shortened week just below
contract highs and only a few cents below record highs. Despite the pronounced price advance over
the previous six-month period, the fundamental picture still appeared bullish because supply and
433
FUNDAMENTAl ANAlySIS AND TRADINg
usage trends suggested the potential for the lowest ending carryover since the early 1950s. The weekly
export report released after the close indicated a huge net sales fi gure in excess of one-half million
bales. This export fi gure confi rmed rumors of potential large sales to China and virtually assured a
very low season ending carryover.
 On the basis of her analysis, Stephanie Statistics had been long for some time. After the release of the
strikingly bullish December 24 export fi gure, Stephanie had to virtually restrain herself from calculating
the potential increase in her open equity as a result of this latest news item. Monday morning the market
opened with near limit gains. “Not bad,” she thought, but the fact that the market did not open locked
limit-up was disconcerting. As the day progressed, prices began to ease and warning bells went off in her
mind. Something was wrong—the market was not really acting right, given the export news. On the
basis of this input, Stephanie liquidated one-third of her position that day, one-third the next day, and the
remaining third one week later. This scaled liquidation refl ected her reluctance to give up a long position
in the cotton market, given what she still perceived to be an extremely bullish fundamental outlook.
 Stephanie’s fundamental view of the market at that time could not have been more off target.
As subsequent events would prove, that Monday was the top of the market (see Figure 29.13 ) and
the start of a yearlong slide—the impending extremely low carry


her reluctance to give up a long position
in the cotton market, given what she still perceived to be an extremely bullish fundamental outlook.
 Stephanie’s fundamental view of the market at that time could not have been more off target.
As subsequent events would prove, that Monday was the top of the market (see Figure 29.13 ) and
the start of a yearlong slide—the impending extremely low carryover notwithstanding. Eventually,
the fundamental explanations for the market’s weakness became evident: high interest rates, a deep
recession, and expectations for a large new crop. However, by that time, prices had already moved
substantially lower (albeit a large portion of the bear move still remained to be realized). The crucial
point is that a contrarian interpretation of a bullish news item provided a long liquidation signal at the
 FIGURE  29.13 July 1981 Cotton
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

434A COMPlETE gUIDE TO THE FUTURES MARKET
market top and prevented an incorrect fundamental market evaluation from transforming a profi table
position into a large loss.
 The preceding story was not a recreation based on artifi cial hindsight. The events described are
true, only the names have been changed to protect the guilty.
 A large price move in response to a seemingly neutral event can also be signifi cant. The FCOJ
market’s response to the October 1993 Crop Production report, which was initially interpreted as
“neutral,” provides an excellent example. This situation and its implications are nicely described from a
trader’s perspective in the following excerpt of an interview of Russell Sands that appeared in Commodity
T raders Consumers Report :
 y esterday there was a crop report. They were expecting between 165 and 180 million
boxes of orange juice. The number came out at 172—right in the middle. The early
call this morning was unchanged to slightly lower. A few minutes before the open they
changed the call to 300 lower. The market opened 700 lower. Now it’s down 900.
 I have no idea what the fundamentals are. I read the crop report yesterday after-
noon, and I thought it would be a quiet day. Maybe the estimates were wrong. Maybe
somebody didn’t believe the estimates. I have no clue as to why this happened. All I
know is there was a neutral report, there was a close-to-unchanged call, but all of a
sudden the market is sharply lower and I didn’t get out. All the fundamental knowl-
edge in the world is not going to save me. I’m scrambling to get out and cut my losses.
 As readers can ascertain in Figure 29.14 , getting out of longs even 900 points lower on the day
in question looked awfully good a few days or a few weeks later. The preceding quotation, which
 FIGURE  29.14 November 1993 FCOJ
Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.

435
FUNDAMENTAl ANAlySIS AND TRADINg
apparently was recorded at the moment of the market event being described, provides a good real-
life illustration of how market response to fundamental news can be utilized as an aid in making
trading decisions.
 ■ Summary
An awareness of the potential limitations of fundamental analysis is essential to its successful appli-
cation. Perhaps the key point to keep in mind is that fundamental analysis is primarily a tool for
forecasting intermediate or long-term price swings and should not be used as a timing indicator. The
only exception to this basic premise is that a counter-to-anticipated market response to fundamental
information could be viewed as a contrarian trading signal (e.g., a bullish fundamental development
would have bearish near-term implications if it failed to elicit the anticipated positive price response).

Futures spreAds
And OptiOns
Part VI

439
Cha P ter 30
There was a one-lot trader named Fred,
who tried to reduce risk with a spread.
But the spread was his demise—
He overdid position size,
trading not 1 but 10 instead.
 ■ Introduction
despite widespread publicity and extensive information, spreads still remain an often misunderstood
and relatively little-used trading vehicle. there is nothing inordinately complicated about spread trad-
ing; many traders simply lack the familiarity with the concepts involved. ironically, it is usually the
novice trader, for whom spreads can be a particularly useful trading vehicle, who shuns them as an
esoteric operation confined to the “pros.” Furthermore, even experienced traders often exhibit a bias
against trading spreads, preferring to trade in outright positions because of their greater potential.
these traders fail to realize that, at times, spreads may offer a more attractive reward/risk ratio than
outright positions. in other words, at a given time, X number of spreads may offer equal potential to
a one-contract outright position but imply a smaller risk. (Of course, such a judgment will always
be subjective.)
the Concepts
and Mechanics of
spread trading
440
A Complete Guide to the Futures mArket
 ■ Spreads—Definition and Basic Concepts
A spread trade involves the simultaneous purchase of one futures contract against the sale of another
futures contract either in the same market or in a related market. normally, the spread trader will
initiate a position 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 a trader 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’s profit would be completely independent of the overall market dir


of price. For
example, if a trader 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’s profit would be completely independent of the overall market direction.
However, this is not to say the spread trader will initiate a trade 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, a spread trader may enter a posi-
tion when he has absolutely no bias regarding future market direction but views a given price differ-
ence as being so extreme that he believes the trade will work, or at worst allow only a modest loss,
regardless of market direction. W e will 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’s trading 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 a one-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 a great flexibility in reducing risk to
a desirable and manageable level, since a spread trade usually presents only a fraction of the
risk involved in an outright position.
1 For example, assume a given spread is judged to involve
approximately one-fifth the risk of an outright position. in such a case, traders for whom a one-
contract outright position involves excessive risk may instead choose to initiate a one-, 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 a reward/risk ratio is a subjective matter. never-
theless, given a trader’s market bias, in a given situation spreads may sometimes offer a better
means of approaching the market.
1 For some markets, reduced-size contracts are available on one or more exchanges.
441
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 a string of limit-up or limit-down moves counter to
one’s position (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 a protective stop) before they can even liquidate their positions.
in contrast, during
a time of successive limit moves, the value of a spread 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. a knowledge and understanding of spreads can also be a valuable aid in trading
outright positions. For example, a failure of the near months to gain sufficiently during a
rally (in those commodities in which a gain can theoretically be expected) may signal the trader
to be wary of an upward move as a possible 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 a valuable aid to the trader. A second way an understanding
of spreads can aid an outright-position trader is by helping identify the best contract month in
which to initiate a position.
the trader with knowledge of spreads should have a distinct 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 a time 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’s discussion.
the intercrop spread is a special case of the intramarket spread involving two different
crop years (e.g., long an old crop month and short a new 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 a long position in one commodity and a short
position in a related commodity. in this type of spread the trader feels the price of a given
442
A Complete Guide to the Futures mArket
commodity is too high or low relative to a closely related commodity. some examples of this
type of spread include long december cattle/short december hogs and long July wheat/short
July corn.


y spread consists of a long position in one commodity and a short
position in a related commodity. in this type of spread the trader feels the price of a given
442
A Complete Guide to the Futures mArket
commodity is too high or low relative to a closely 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 a commodity and its by-product(s)—for
example, soybeans versus soybean meal and/or soybean oil—is a specific 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, a trader might decide the premium of cattle to hogs is too small
and will likely increase. this trading bias would dictate the initiation of a long 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 a case, 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, a euro/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 a commodity 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 Y ork 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 a major consideration. intermarket spread trading is often referred to as arbitrage. As
a rule, the intermarket spread requires a greater degree of sophistication and comprehensive
familiarity with the commodity in question than other types of spreads.
443
tHe COnCepts And MeCHAniCs OF spreAd trAding
 ■ The General Rule
For many commodities, the intramarket spread can often, but not always, be used as a proxy for an
outright long or short position. As a general rule, near months will gain ground relative to distant
months in a bull market and lose ground in a bear market.
the reason for this behavior is that a bull
market usually reflects a current tight supply situation and often will place a premium on more imme-
diately available supplies.
in a bear 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 a period of time.
thus, if a trader expects a major bull move, he can often buy a nearby
month and sell a more distant month. if he is correct in his analysis of the market and a bull move
does materialize, the nearby contract will likely gain on the distant contract, resulting in a success-
ful trade.
it is critical to keep in mind that this general rule is just that, and is meant only as a rough
guideline. there are a number of commodities for which this rule does not apply, and even in those
commodities where it does apply, there are important exceptions. W e will elaborate on the question
of applicability in the next section.
At this point the question might legitimately be posed, “
if the success of a given spread trade is
contingent upon forecasting the direction of the market, wouldn’t the 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 a correspond-
ingly greater risk.
sometimes the outright position will offer a better reward/risk ratio; at other
times the spread will offer a more attractive trade. A determination of which is the better approach
will depend upon absolute price levels, prevailing price differences, and the trader’s subjective 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 a given point in time the premium of a nearby month may already be excessively wide, and
consequently a general price rise in the market may fail to widen the spread further.
 2. s ince hig


ng
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 a given point in time the premium of a nearby month may already be excessively wide, and
consequently a general price rise in the market may fail to widen the spread further.
 2. s ince higher prices also increase carrying costs (see section entitled “the Limited-risk spread”),
it is theoretically possible for a price increase to widen the discount of nearby months in a
surplus market. Although such a spread response to higher prices is atypical, its probability of
occurrence will increase in a high-interest-rate environment.
444
A Complete Guide to the Futures mArket
 3. s preads involving a spot 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. A bull move that is primarily technical in nature may fail to influence a widening of the nearby
premiums since no real near-term tightness exists. (
such a price advance will usually only be
temporary in nature.)
 5. g overnment 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 a ris-
ing market distant months gain relative to more nearby contracts, and in a declining market they lose
relative to the nearby positions. In fact, in these markets, a long forward/short nearby spread is often a good
proxy for an outright long position, and the reverse spread can be a substitute position for an outright short.
in
each of these markets nearby months almost invariably trade at a discount, 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 a wider discount in a
bull 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’s
changing perception of their value.
in a bull 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 a few 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). W e will 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 a completely 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 a small measure of
flexibility, in that they can market an animal before it reaches optimum weight or hold it for a while
after. However, economic considerations will place strong limits on the extent of such marketing
445
tHe COnCepts And MeCHAniCs OF spreAd trAding
shifts.) As a consequence of the intrinsic nature of this commodity, different months in live cattle are,
in a sense, different commodities. June live cattle is a very different commodity from december live
cattle. the price of each will be dependent on the market’s perception of the supply-demand picture
that it expects to prevail at each given time period. it is not unusual for a key cattle on feed report to
carry bullish implications for near months and bearish connotations for distant months, or vice versa.
in such a case, the futures market can often react by moving in opposite directions for the near and
distant contracts. the key point is that in a bullish (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). A similar 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 a given 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 a long
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 e


lacing 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 a long
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 a spread’s life 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’s perception of the fundamentals, which may or may not be the same.
 ■ Spread Rather Than Outright—An Example
Frequently, the volatility of a given market may be so extreme that even a one-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 a higher 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 a low-risk trader believed
that prevailing nearest futures prices near $2.22 in mid-October 2014 were unsustainable, but based
on the market’s volatility (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 a trader could
instead have entered a bear 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 a much
larger profit is an irrelevant consideration, since the trader’s risk limitations would have prevented him
from participating in the bear move altogether had his market view been confined to outright trades.
446A COMpLete guide tO tHe Futures MArKet
 ■ The Limited-Risk Spread
 the limited-risk spread is a type of intracommodity spread involving the buying of a near month
(relatively speaking) and the selling of a more distant month in a storable commodity in which the
process of taking delivery, storing, and redelivering at a later 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 a commodity fulfi lling the above specifi cations, the maximum premium that a more distant
month can command over a nearby 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 a discount. 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 t echnologies, 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 a change in carrying charges. in
contrast, the purpose of a limited-risk spread is to profi t from an expected narrowing of the spread relative to
the level implied by carrying charges (which are assumed to remain constant).
447
tHe COnCepts And MeCHAniCs OF spreAd trAding
spread is equal to 200 points, a long October/short december spread initiated at October 100 points
under might be termed a limited-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 a distant month to exceed car-
rying costs is to assume the existence of a situation where this is indeed the case. in such an instance,
a trader who bought a nearby month and sold a more distant month would have an opportunity for
speculative gain and, at worst, would have the option of taking delivery, storing, and redelivering at
a likely profit (since we assumed a situation 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 a spread difference to even approach full carry since, as it does, the opportunity exists for
a speculative trade that has very limited risk but, theoretically, no limit on upside potential.
in othe


nds 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 a spread difference to even approach full carry since, as it does, the opportunity exists for
a speculative 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 a surface glance, limited-risk spreads seem to be highly attractive trades, and indeed they often
are. However, it should be emphasized that just because a spread is relatively near full carry does not neces-
sarily mean it is an attractive trade. V ery often, such spreads will move still closer to full carry, resulting
in a loss, or trade sluggishly in a narrow 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 a limited 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. W e will
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 a trader ever lose more money in a limited-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 a spread trade to increase
as a result of fluctuations in carrying costs. For example, a trader might enter a long October/short
december cotton spread at 100 points October under, at a time when full carry approximates 200
points—implying a maximum 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’s risk 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 a limited-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 a limited-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 a possible 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 a number 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 a sharply declining market, the nearby month can move
to a discount exceeding full carry as the forward month is contained by price limits. Although this
situation will usually correct itself within a few days, in the interim, it can generate a substantial 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 a final word, it should be emphasized that although there is a theoretical limit on the premium that
a distant month can command over a nearby contract in carrying-charge markets, there is no similar limit on the
premium that a nearby position can command.
nearby premiums are usually indicative of a tight 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
A logical starting point is a survey 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 a spreadsheet) are unavailable, the trader should, if possible, scan historical price
data, checking the difference of the given spread on a biweekly or monthly basis for at least the past
5 to 10 years.
this can prove to be a time-consuming endeavor, but a spread trade initiated without
any concept of historical patterns is, in a sense, a shot in the dark. Although spreads can deviate
widely from historic


are unavailable, the trader should, if possible, scan historical price
data, checking the difference of the given spread on a biweekly or monthly basis for at least the past
5 to 10 years.
this can prove to be a time-consuming endeavor, but a spread trade initiated without
any concept of historical patterns is, in a sense, a shot in the dark. Although spreads can deviate
widely from historical patterns, it is still important to know the normal range of a spread, as well as
its “average” level.
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tHe COnCepts And MeCHAniCs OF spreAd trAding
Step 2: Isolation of Similar Periods
As a rule, spreads will tend to act similarly in similar situations. thus, the next step would be a refine-
ment of step 1 by means of isolating roughly similar periods. For example, in a high-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’s behavior 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 a further refinement of step 1. sometimes a spread will tend to display a distinct seasonal
pattern. For example, a given spread may tend to widen or narrow during a specific period. Knowledge
of such a seasonality can be critically important in deciding whether or not to initiate a given spread.
For example, if in nine of the past 10 seasons the near month of a given spread lost ground to the distant
month during the March–June period, one should think twice about initiating a bull spread in March.
Step 4: analysis and Implications of relevant Fundamentals
this step would require the formulation of a concept 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
A key step before initiating a spread trade should be the examination of a current chart of the spread
(or the use of some other technical input). As in outright positions, charts are an invaluable informa-
tional tool and a critical aid to timing.
 ■ Pitfalls and Points of Caution
 ■ do not automatically assume a spread is necessarily a low-risk trade. in some instances, a spread
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 a spread because of its lower risks or margin. A 5- to 10-contract
spread position gone astray can often prove more costly than a bad one-contract outright trade.
Overtrading is a very common error in spread trading.
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A Complete Guide to the Futures mArket
 ■ As a general 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. A lack of liquidity can significantly increase the loss when getting
out of a spread that has gone awry. At times, of course, a given spread may be sufficiently attrac-
tive despite its less-than-desirable liquidity.
nevertheless, even in such a case, it is important that
traders be aware of the extra risk involved.
 ■ place a spread order on a spread basis rather than as two separate outright orders. some traders
place their spread orders one leg at a time in the hopes of initiating their position at a better 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 a momentary concentration of orders in
a given contract month, can often result in outright price quotations implying totally unrepresen-
tative spread values.
 ■ do not liquidate spreads one leg at a time. Failing to liquidate the entire spread position at one
time is another common and costly error, which has caused many a good spread trade to end in
a loss.
 ■ 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 a limited-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 a spread.
 ■ 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 a losing position.
in most cases such a move amounts to little more than fooling oneself and often can exacerbate
the loss.
451
tHe COnCepts And MeCHAniCs OF spreAd trAding
 ■ Because it is especially easy to procrastinate in liquidating a losing spread position, the


that has gone sour—that is, do not initiate an
opposite direction position in another contract as an alternative to liquidating a losing position.
in most cases such a move amounts to little more than fooling oneself and often can exacerbate
the loss.
451
tHe COnCepts And MeCHAniCs OF spreAd trAding
 ■ Because it is especially easy to procrastinate in liquidating a losing spread position, the spread
trader needs to be particularly vigilant in adhering to risk management principals. it is advisable
that the spread trader determine a mental stop point (usually on the basis of closing values) prior
to entering a spread 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 a significant percentage of the profit potential, reducing the odds of a net winning out-
come.
in short, the odds are stacked against the very-low-risk spread trader.
 ■ As a corollary to the prior item, a trader 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 a greater-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 a two-unit March/May corn spread, since a one-unit March/July
corn spread would offer a very similar potential/risk trade at half the transaction cost.

453
. . . many more people see than weigh.
—Philip Dormar Stanhope, Earl of Chesterfield
B
y definition, the intention of the spread trader is to implement a position that will reflect changes
in the price difference between contracts rather than changes in outright price levels. T o achieve
such a trade, the two legs of a spread must be equally weighted. As an obvious example, long 2
December corn/short 1 March corn is a spread in name only. Such a position 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 a balanced 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 a trader who anticipates that demand for lower quality Robusta coffee
beans (London contract) will decline relative to higher quality Arabica beans (New Y ork 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 Y ork 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 Y ork 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 Y ork 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 Y ork 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 Y ork and London coffee contracts are different: The size of the New Y ork 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 a conversion into $/pound for easier comparison with the New Y ork coffee contract.)
Because of this disparity, an equal contract position really implies a larger commitment in New Y ork
coffee. Consequently, such a spread position is biased toward gaining in bull coffee markets (assuming
the long position is in New Y ork coffee) and losing in bear markets. The long New Y ork/short London
spread position in our example actually loses $2,218 plus commissions, despite the larger decline in
London coffee prices:
Profit/los so f co ntractso f units per c ontrac 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/l oss 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 Y ork 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 Y ork coffee/London coffee spread, each New Y ork coffee contract would be offset by
1.7 (37,500/22,043) London coffee contracts, implying a minimum equal-unit spread of five London
coffee versus three New Y ork cof


larger-unit contract (i.e., New Y ork 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 Y ork coffee/London coffee spread, each New Y ork coffee contract would be offset by
1.7 (37,500/22,043) London coffee contracts, implying a minimum equal-unit spread of five London
coffee versus three New Y ork 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 f co ntractso f units per c ontrac 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/l oss 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 Y ork 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 Y ork 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.
455
IntercommodIty SpreadS: determInIng contract ratIoS
The fact that percentage price change is a more 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 a position 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 a ratio
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 Y ork
coffee/London coffee).
Thus we adopt the definition that a balanced spread is a spread 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|| ,, ,t t
tt
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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A Complete Guide to the Futures mArket
can be achieved by using a contract ratio that is inversely proportional to the contract value (CV) ratio.
This can be expressed as follows (see footnote 2 for symbol definitions):
N
N
CV
CV
UP
UP
t
t
2
1
1
2
11 0
22 0
== =
=
,
,
or, NN CV
CV21
1
2
= 





For example, if New Y ork coffee is trading at $1.41/lb and London coffee at $.80/lb, the equal-dollar-
value spread would indicate a contract ratio of 1 New Y ork coffee/3 London coffee:
NN CV
CV N UP
UP
t
t
21
1
2
1
11 0
22 0
= 




 =






=
=
,
,
If New York coffee contractN1 1= ,
N2 =× ×=37 5001 41/22 0430 80 3 London contracts,$ ., $.
Thus, in an equal-dollar-value spread position, 3 New Y ork coffee contracts would be balanced by 9
(not 5) London contracts.
It may help clarify matters to compare the just-defined equal-dollar-value approach to the
equal-unit approach for the case of the New Y ork coffee/London coffee spread. Although the equal-
unit spread is indifferent to equal absolute price changes, it will be affected by equal-percentage
price changes (unless, of course, the price levels in both markets are equal, in which case the two
approaches are equivalent). For example, given initiation price levels of New Y ork coffee = $1.41/lb
and London coff