This is textbook stuff. “Sell fear, buy reality” – that’s my spin on the old saying “buy rumour, sell fact”. It’s been an interesting two weeks in the Hogs pit. The events of the last two weeks are a perfect example of how logical spread trading can be.
On a trip to the CME floor just a few days after the initial news, I had some interesting conversations with a few traders in the Lean Hogs pit. Most of the initial news hit the market on the weekend of the 25th and 26th or May, so on return to trading Monday, the markets gapped sharply lower. The trading day caught a lot of people out and those that tried to cover positions didn’t do too well.
Remember all the hype on the news at the time? Pandemic? Epidemic? If we listened to the news, particularly the US news, no one was safe. But those media producers know what will sell. For example, which headline below do you think will attract more attention?
Markets, like people react to these things too. People overreact and markets overreact. Here is what happened in the pit for the August and December contracts that day.
If you were long going into this trading session, you were in trouble. Getting fills on days like this, particularly if you scrambling to cover a losing position is very hard. Volume did increase on this day, but it was a tough day in the pits.
So how to do you make money from movement like this? I’ll get to that, but first let’s look at how/why each contract moved.
From Friday close to Monday close, the August contract fell 2.975pts. The fall in the Dec contract was not as severe, losing 2.40pts.
Both contracts fell as worries about the “swine” flu may have meant a drop in demand for pork products – that’s common sense when you think about it. But why didn’t they each move by the same amount? The nearer contract fell further that the Dec one because the market saw a higher chance of the flu having a temporary impact as opposed to a prolonged one.
Again, this is a common sense concept or at least a fair bet. It’s a fair bet that someone would work out how to contain or resolve the problem pretty quickly (despite what the media said).
The next few days
Remember that “sell fear, buy reality” idea? Have a look at how the market traded in the days subsequent to the initial news. Below is the Dec contract. The worst day of “fear” was the Tuesday. Then as people and media calmed down, the market not only returned to where it was before the news, it moved higher. So much for a pandemic, huh?
As for the August contract, than one rallied too, but not as much (for the same reason the market fell further to start with).
OK, so let’s get back to the question on how to make money from news like this? One way is to just trade the futures contracts outright. Go short into fear, go long when things begin to settle. The problem with that however is the volatility. It’s not difficult to manage if you can afford to sit in front of the screen all day. Without constant monitoring, you can get squeezed pretty bad.
An alternative to trading outright futures contracts is the trade the spread price between the two. That’s what most floor traders I have spoken with including those in the Hogs pit do. It’s also what the ProTrader Digest shows you how to do.
Along with far lower margin deposit rates, the benefits are lower volatility in your trading and a trading style that is less reliant to exact to the minute timing. In other words, it’s easier to make money – at least that is my opinion and experience.
Remember how volatile the outright contracts were in the above discussion? Now take a look at the spread price between the August and Dec contract.
The chart shows the December price less the August price. You can buy this spread by buying the December contract and selling the August one.
Just by looking at this chart, you can see trading the spread is a more sensible way of doing things. You can also understand why many floor traders prefer spreads.
For the technical traders out there, spread trading can offer more predictable trends and simple signals. Just look at the above spread chart, several indicators including.
In a way, you could think of it as a smarter way to trade the markets. It’s interesting to see many new subscribers to the ProTrader Digest are new to futures trading. Most have traded stocks and maybe some FX, but not futures.
At first spread trading may seem a little difficult, but recent action in the Hogs pit shows there is a lot of logic to it. The trading ideas posted on the ProTrader Digest site not only explain the statistics behind the trade, but the logic also. It means you learn as you go and feel comfortable with what you are doing.
Not only that, the trades posted to date have shown pretty impressive results. Click here for complete trades and performance details.
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