40 lines
3.5 KiB
Plaintext
40 lines
3.5 KiB
Plaintext
454
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A Complete Guide to the Futures mArket
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attempts to capitalize on this forecast by initiating a 5-contract long New Y ork coffee/short London
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coffee spread. Assume the projection is correct, and London coffee prices decline from $0.80/lb to
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$0.65/lb, while New Y ork coffee prices simultaneously decline from $1.41/lb to $1.31/lb. At sur-
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face glance, it might appear this trade is successful, since the trader is short London coffee (which has
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declined by $0.15/lb) and long New Y ork coffee (which has lost only $0.10/lb). However, the trade
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actually loses money (even excluding commissions). The explanation lies in the fact that the contract
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sizes for the New Y ork and London coffee contracts are different: The size of the New Y ork coffee
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contract is 37,500 lb, while the size of the London coffee contract is 10 metric tonnes, or 22,043 lb.
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(Note: In practice, the London coffee contract is quoted in dollars/tonne; the calculations in this sec-
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tion reflect a conversion into $/pound for easier comparison with the New Y ork coffee contract.)
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Because of this disparity, an equal contract position really implies a larger commitment in New Y ork
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coffee. Consequently, such a spread position is biased toward gaining in bull coffee markets (assuming
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the long position is in New Y ork coffee) and losing in bear markets. The long New Y ork/short London
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spread position in our example actually loses $2,218 plus commissions, despite the larger decline in
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London coffee prices:
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Profit/los so f co ntractso f units per c ontrac tg ain/loss=× ×## per un it
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Profit/loss in long New York coffee positio n5 37 5000=× ×−,( $. .) $,10/lb1 8 750=−
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Profit/loss in short London coffee position = 52 20 43×× +,( $001 5/lb 16 532.) $,=+
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Net profit/l oss in sprea d2 218=− $,
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The difference in contract size between the two markets could have been offset by adjusting the
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contract ratio of the spread to equalize the long and short positions in terms of units (lb). The gen-
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eral procedure would be to place U1/U2 contracts of the smaller-unit market (i.e., London coffee)
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against each contract of the larger-unit contract (i.e., New Y ork coffee). (U1 and U2 represent the
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number of units per contract in the respective markets—U1 = 37,500 lb and U2 = 22,043 lb.) Thus,
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in the New Y ork coffee/London coffee spread, each New Y ork coffee contract would be offset by
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1.7 (37,500/22,043) London coffee contracts, implying a minimum equal-unit spread of five London
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coffee versus three New Y ork coffee (rounding down the theoretical 5.1-contract London coffee posi-
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tion to 5 contracts.) This unit-equalized spread would have been profitable in the above example:
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Profit/los so f co ntractso f units per c ontrac tg ain/loss=× ×## per un it
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Profit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10/lb1 1 250=−
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Profit/loss in short London coffee position 52 20 43 0=× ×+,( $. 115/lb +1 6 532)$ ,=
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Net profit/l oss in sprea d+ 5 282= $,
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The unit-size adjustment, however, is not the end of our story. It can be argued that even the
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equalized-unit New Y ork coffee/London coffee spread is still unbalanced, since there is another signifi-
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cant difference between the two markets: London coffee prices are lower than New Y ork coffee prices.
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This observation raises the question of whether it is more important to neutralize the spread against
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equal price moves or equal-percentage price moves. The rationale for the latter approach is that, all
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else being equal, the magnitude of price changes is likely to be greater in the higher-priced market. |