47 lines
3.9 KiB
Plaintext
47 lines
3.9 KiB
Plaintext
447
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tHe COnCepts And MeCHAniCs OF spreAd trAding
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spread is equal to 200 points, a long October/short december spread initiated at October 100 points
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under might be termed a limited-risk spread. However, the same long October/short december
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cotton spread would not be termed limited risk if, for example, October were at a 300-point pre-
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mium. nevertheless, it should be noted that even in this latter case, the maximum risk would still be
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defined—namely, 500 points—and in this respect the spread would still differ from spreads involving
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the selling of the nearby contract, or spreads in markets that do not fulfill the limited-risk specifica-
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tions detailed above.
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the best way to understand why it is unlikely for the premium of a distant month to exceed car-
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rying costs is to assume the existence of a situation where this is indeed the case. in such an instance,
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a trader who bought a nearby month and sold a more distant month would have an opportunity for
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speculative gain and, at worst, would have the option of taking delivery, storing, and redelivering at
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a likely profit (since we assumed a situation in which the premium of the distant month exceeded
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carrying charges).
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sounds too good to be true? Of course, and for this reason differences beyond full
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carry are quite rare unless there are technical problems in the delivery process. in fact, it is usually
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unlikely for a spread difference to even approach full carry since, as it does, the opportunity exists for
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a speculative trade that has very limited risk but, theoretically, no limit on upside potential.
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in other
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words, as spreads approach full carry, some traders will initiate long nearby/short forward spreads
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with the idea that there is always the possibility of gain, but, at worst, the loss will be minimal. For
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this reason, spreads will usually never reach full carry.
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At a surface glance, limited-risk spreads seem to be highly attractive trades, and indeed they often
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are. However, it should be emphasized that just because a spread is relatively near full carry does not neces-
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sarily mean it is an attractive trade. V ery often, such spreads will move still closer to full carry, resulting
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in a loss, or trade sluggishly in a narrow range, tying up capital that could be used elsewhere. How-
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ever, if the trader has reason to believe the nearby month should gain on the distant, the fact that the
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spread has a limited risk (the difference between full carry and the current spread differential) makes
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the trade particularly attractive.
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the components of carrying costs include interest, storage, insurance, and commission. W e will
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not digress into the area of calculating carrying charges. ( such information can be obtained either
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through the exchanges themselves or through commodity brokers or analysts specializing in the given
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commodity.) However, we would emphasize that the various components of carrying charges are
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variable rather than fixed, and consequently carrying charges can fluctuate quite widely over time.
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interest
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costs are usually the main component of carrying charges and are dependent on interest rates and
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price levels, both of which are sometimes highly volatile.
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it is critical to keep changes in carrying costs
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in mind when making historical comparisons.
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Can a trader ever lose more money in a limited-risk spread than the amount implied by the differ-
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ence between full carry and the spread differential at which the trade was initiated? the answer is that
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although such an occurrence is unlikely, it is possible. For one thing, as we indicated above, carrying
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charges are variable, and it is possible for the theoretical maximum loss of a spread trade to increase
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as a result of fluctuations in carrying costs. For example, a trader might enter a long October/short
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december cotton spread at 100 points October under, at a time when full carry approximates 200
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points—implying a maximum risk of 100 points. However, in ensuing months, it is possible higher |