To Spread or Not To Spread

The Daily Reckoning PRESENTS: Next to options trading, spread trading confuses more new traders than any other type of trading order. Luckily, our resident commodities guru, Kevin Kerr, is here to explain. Read on…

TO SPREAD OR NOT TO SPREAD

It’s actually quite simple if you don’t let all the jargon make you nervous. Basically, what you’re doing is taking a simultaneous long and short position in an attempt to profit. The profit comes from the differential, or “spread,” between two prices. A spread can be established between different months of the same commodity (called an interdelivery spread), between the same or related commodities, usually for the same month (intercommodity spread), or between the same or related commodities traded on two different exchanges (intermarket spread).

You can enter a spread order at the market or you can designate that you want to be filled when the price difference between the commodities reaches a certain point (or premium). Take this spread example: We want to buy 1 June Live Cattle and Sell 1 August Live cattle when the August cattle contract is 100 points higher than the June contract.  The order would read something like this:

BUY 1 JUNE LIVE CATTLE, SELL 1 AUGUST

LIVE CATTLE PLUS 100 TO THE AUGUST SELL SIDE.

Sounds confusing but it’s not, trust me. Again, all this means is that you want to initiate or liquidate the spread when the August cattle contract price is 100 points higher than the June cattle. These days, most exchanges don’t report spread transactions on their quote boards, but a few do. The best way is to find out from your broker who will call the trading floor or the order desk and ask them to get a “fresh quote.”  Another way to figure out where a spread may be is to take the two prices and simply add or subtract one from the other. Always confirm this with your broker or the trading floor before entering any spread trade.

Just like everything in commodities, after you get used to the basics of spreads you’ll become aware of more complex strategies that include but are not limited to things like: Condor spreads, Crack spreads, Crush spreads–the list goes on ad infinitum. No, a condor isn’t some exotic bird of prey, it’s just trading-ese for a rather exotic spread trade. Condor spreads are sometimes referred to as “elongated butterflies.” That helps a lot, right? Let’s try another approach.

Take a long call condor spread. This bird consists of a long call of a lower strike, one short call of a second strike, one short call of a third strike and, finally, a long call of a fourth strike. The calls have the same expiration, and the strikes are equal distance apart. Now you’re probably scratching your head saying…”When would I ever use this?”  Exactly!  A condor spread is such a specialized strategy that it’s hard to say what the individual’s reasoning would be for using it; it would be different on a case-by-case basis.

I will say that spread trading – even complicated spreads like condors – can have value for some investors. Now I’m in no way advocating this type of trading, even for the seasoned options trader like myself.  The biggest and most glaring problem with these complex spreads are that the only person that usually makes money is your broker. Condor spreads, like butterfly spreads, involve significant transaction costs which make them prohibitive for option traders who do not qualify for major commission discounts. The cost of this position must be examined carefully before establishing it.

The best thing to do is avoid trading any of these complex option strategies altogether.  The risks of these option spreads far outweigh the advantages, and sometimes are far more hassle then they could ever be worth.

Some other types of spreads are more mainstream and do offer good opportunity. Two of those involve a main commodity that has products created or derived from it. A crush spread, for example, is simply a spread between soybeans and soybean meal and or soybean oil, sometimes called “putting on the crush.” A crack spread has nothing to do with illegal drugs; it’s the same type of spread as the crush, only involving crude oil and unleaded gasoline and /or heating oil.

Let me interrupt myself for a second–I know all of this lingo can sound like mumbo jumbo, but rest assured that as you need to know these things you will. I myself, when I was first introduced to the markets, felt completely lost. I was utterly bombarded with a whole spectrum of new expressions and terms my first few weeks on the trading floor. While the old saying “fake it till you make it” worked for me,  I suggest instead finding a broker or trading mentor, much like my readers have found in me. Use this person, ask questions, solicit advice, and whenever you’re not sure of what the terminology means, ask.

In my experience, people usually like nothing better than to talk about themselves; they like to teach someone something they know.  So never hesitate to ask the questions; after all, it’s the only way you’ll learn.

Spreads can be very valuable and profitable but it’s important to start with the basics and then move on to the more exotic stuff when and if appropriate. Whenever I have an important decision to make I make two lists, Pro vs. Con. Here are some basic pros and cons of spread trading:

PROS

Spreads in commodity futures offer lower margin rates because these strategies usually carry less risk. (We’ll talk more about margins in a minute.)

Spreads are usually less volatile and prices move less quickly, which can be good for beginners who may be intimidated by the speed and price fluctuations of a single outright trade in the futures market.

Spreads offer unique hedging opportunities in a variety of commodities.

Certain types of spread trading allow the trader to pay less in margin, funding the purchased future or option with the sale of the other side of the spread, thus reducing initial costs.

CONS

Spread trading has much higher transaction (commission) costs because you’re using more than one trading vehicle. That’s why it’s even more important for a spread trader to have an excellent entry and exit point, because every penny will count.

Spreads are often not traded “outright”; in other words on their own in some commodities, so you must “leg” into them, which can be tricky for the novice. (More about outrights vs. legging into trades in the section on “Locals,” later on.)

Spreads can be less liquid than other trades, which could prove to be disastrous if you’re trying to get out of a position in a hurry.

Spreads have limited profit potential most of the time. For example, if a trader buys July corn and sells December and the July rallies but the December contract doesn’t really fall by much, and in fact rallies too, then the trader’s profits would be limited and the extra commissions would cut into what little profit the trader made.

Spread trading can be confusing, especially to the newer trader.

My final word on spread trading: It can be effective, but before entering into any spread trade figure out if you really have a reason to be using this type of trade, what purpose does it serve?  If the answer is clear to you then go right ahead.  Remember the most important thing to watch with spreads are those pesky transaction costs – they can really add up, fast.

Regards,

Kevin Kerr
for The Daily Reckoning
March 29, 2007

P.S. In Outstanding Investments and Resource Trader Alert, we often write about the most profitable ways to play the commodities and natural resource markets – and our readers have been quite pleased with the results. That’s why we’ve decided to package all of our commodity-related publications together in one easy package so you can effortlessly take advantage of the next leg of the massive commodity super boom.

Editor’s Note: Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.

The above was taken from Kevin’s soon-to-be-released book, A Maniac Commodity Trader’s Guide to Making a Fortune. In the book, Kevin dispels the common myths and misconceptions about these markets, offering an insider’s view of what he calls “the last bastion of pure capitalism on Earth.” Whether you’re a novice or an experienced trader, Kevin’s down-to-earth, clear-cut guidance will make you more savvy, more confident, and more able to jump right in and grab those profit opportunities that are waiting for you. The book is available for pre-sale here:

A Maniac Commodity Trader’s Guide to Making a Fortune

Prime slips…and slides into subprime.

Problems in subprime mortgage loans could be spreading into subprime auto loans…and subprime commercial loans.

As to the subprime auto and truck loans alone, there are some $34 billion outstanding. As to the rest of the loans that were made to shaky borrowers, without proper credit standards, the total may reach into the hundreds of billions.

And what about politics? Isn’t the U.S. government operating at subprime levels? And aren’t the candidates for next year’s presidential election also less than prime?

Oh where…oh where…dear reader…shall we begin?

No big breaks in the financial markets yesterday. But the millwheels keep grinding – turning the pretensions of the smart…the conceits of the powerful…the assets of the rich – all to dust.

When standards go out the window, they just don’t go out of windows in trailer parks and ghettos. They go out of windows in gated communities in Florida and Washington. And they would go out of windows of skyscrapers in Manhattan and London, if you could only open the windows.

Even in education and art…standards slip.

We were looking at Henry’s report card last night. Ai yi yi…

“Needs to work harder…” said his science teacher.

“Performing below his capacity…” said his math teacher.

“Work okay…but could be much better…” said his Latin teacher.

The half-empty part of that glass was obvious. But there was a half-full part too.

Henry does his homework until midnight every night…and works on it at least 8 hours each weekend. And still, his teachers aren’t satisfied.

We checked his grades and class ranking (in France, every student knows exactly where he stands) and found that Henry is above the average in what must be one of the toughest schools in France. Ah ha! A school with STANDARDS.

From what we’ve heard, in most of the schools in France – and America – students get passing grades, even without really knowing anything.

Meanwhile, yesterday, Elizabeth came back from an exhibit of Greek statues…attributed to Praxiteles or his imitators.

“It was unbelievable,” she remarked. “The sculptures had such dignity. It is incredible that they were done more than 2,000 years ago.”

A thought crossed our mind. How many of today’s artists could create a beautiful statue out of a block of marble?

But blocks of marble are not our beat here at the Daily Reckoning, so let us get back to money.

What is endangering America’s money is the same thing that is undermining its position in the world – slipping standards.

And slipping standards is what had brought about the fifth of our Big E’s.

We began to review our Four Big E trends the other day: Energy, Experimental Money (the faith-backed dollar), and the Exodus of power and wealth from West to East. Today, we look at our fourth – the Empire.

When we say that America is an Empire, it is neither a matter of desire or reproach. It is simply an observation.

Some readers think it is unpatriotic or un-American to notice. But while a good husband doesn’t notice when his wife gets fat, perhaps, a citizen with his wits about him might do well to keep a close eye on his government. And if he looks carefully at America circa 2007 he will see that it more closely resembles an empire, rather than a modest republic. Its troops…its culture…and its commerce…impose themselves over almost the entire planet.

Empires must be empires and follow the imperial path…from humbug, to farce, to disaster. They must believe what isn’t true (that they have some intrinsic, inalienable advantage)…and they must relax their standards…as they stretch…and then overstretch…until they have stretched too far.

Nine trillion dollars in federal debt…a ‘fiscal gap’ 50 trillion dollars wide… an $800 billion trade deficit…an everlasting War on Terror…

And in today’s news comes word that the United States is “no longer technology king.”

The BBC reports:

“The US has lost its position as the world’s primary engine of technology innovation, according to a report by the World Economic Forum.

“The US is now ranked seventh in the body’s league table measuring the impact of technology on the development of nations.

“A deterioration of the political and regulatory environment in the US prompted the fall, the report said.”

And more bad news…Alan Blinder writes in the Wall Street Journal that globalized competition could cost the United States as many as 40 million jobs over the next two decades. Fifty years ago, America was the world’s most competitive economy. Now, Asians have an edge when it comes to low cost production, and Europeans have an edge when it comes to innovation and high quality production. The Empire is peaking out.

What will it do when it can’t pay its bills? We’re going to find out…

More news…

————–

A few birthday wishes from our resident peak oil expert Byron King:

“Has it really been 188 years? It seems like only yesterday that Edwin Drake was born on March 29, 1819 in Greenville, New York. ‘Tempus fugit,’ as I learned in Latin class long ago.

“And it seems like not very long ago that the good Col. Drake pounded down his oil well at Titusville, Pennsylvania in August 1859. That first oil well produced all of 25 barrels per day, albeit in a world where there was nothing else quite like it. Today, the world produces and consumes some 85 million barrels of oil per day. That is the equivalent of about 1,000 barrels per second, and does not include the natural gas wells of the planet. What a difference one man can make, especially when his work compounds over about a century and one-half.”

————–

And more views:

*** Et tu, Dear Reader?

“The Daily Reckoning is too long.” That’s what readers tell us. We’re sorry. But we don’t have time to write something short.

*** And we promised to explain our Theory of Modern Politics…

The question before is, “Why have all governments – including the supposedly freedom-loving U.S. of A – edged towards collectivism?”

We begin with a conversation we had with our bus driver. The last two days were spent at the Chateau de Courtomer, where we were attending a conference with Addison and Eric and many others on the Daily Reckoning team. The days were bright and sunny; the conversation quick and agreeable; the wine soft and smooth.

Coming back, we sat up next to the bus driver, where we could get a good view of the rolling Normandy hills.

“I worry about what will happen to our kids and grandchildren…about what kind of world they’re going to live in,” he said.

He was a very-French looking man of about 50, with a full head of dark hair with gray streaks in it, and an ironic smile. He wore a tie, and might have passed for a waiter in a good restaurant.

“I started my career as a chauffeur 30 years ago,” he went on. “Back then, you had no trouble getting a job. And they didn’t ask you a million questions or tell you what to do. You just had to drive the bus.

“But now, everything is regulated. Everything. I can’t drive more than 4 hours without stopping for a 45-minute break. That’s why I couldn’t move the bus out of the parking lot when we got to the chateau. I had to stay there and do nothing for 45 minutes. The 45-minute break is supposed to be a safety measure. But, the effect of it was that I was driving at night…and I was tired.

“Back when I started, I could decide for myself. But now everything is decided for us.”

We believe he is on to something. Just look at the current issue of Fortune Magazine for proof. It is supposedly the voice of conservative, capitalistic freedom lovers – people who treasure the liberty of the individual to decide for himself when to drive his bus…or how to organize his work…or how to spend his money.

“Fix the health care system: Raise taxes,” says the headline. “Sometimes raising taxes makes sense, even to conservatives.”

The writer, Matt Miller, goes on to explain that there is an “opening of the capitalist mind” going on, allowing the old robber barons to appreciate the benefits of taxation.

We almost fell out of our chair when we realized what he was proposing; we were laughing so hard.

The story is this: Employers are finding it hard to keep up with the cost of health care benefits. For example, another article explains that a 65-year-old couple, not covered by a private health care plan, should plan on spending $215,000 on health care through the end of their lives – an amount up 7% from the year before.

But far as we have observed, there is no direct relationship between spending money and enjoying good health. Many of the most expensive health problems are simply a result of bad habits. We suspect that 90% of heath-care expenditures is unnecessary or inefficient, or both. But if people want to spend their money on health care, well…it’s their money.

Already, company-sponsored health care is collectivized. But it is collectivized privately…and honestly. For the most part, employers and employees can decide for themselves what they want to do about their health and how much they want to spend on it. But employees want health care benefits…and many employers have health care plans with crushing legacy costs.

So what do they want to do? Own up to the fact that they their costs are out of control? Raise the standards…and cut the costs? Figure out how to fix their own health care system problems? No, they want to shove the costs of their health care obligations onto the general taxpayer! They want a program of forced collectivization – where their employees spend someone else’s money on their health…and where the government will be ultimately responsible for the health care of everyone in the country.

Most likely, the pseudo-conservatives at FORTUNE will get their wish. George W. Bush went a long way towards forced collectivization of health care costs with his big drug bill. The next president is likely to go even further.

And so…the whole world goes in Marx’s direction…in Bismarck’s direction…away from Liberte and towards Egalite…away from the Theory of the Individual and towards the Theory of the Collective.

Why? More to come…