Feature Stories | Apr 19 2010
This article was first published a week ago for the benefit of FNArena subscribers.
Prologue
By Greg Peel
Australian banks are a popular stock market investment and for good reason – they represent a significant proportion of market capitalisation. Similarly, resource stocks, particularly the big boys, are a significant proportion of the index. Longer term investors in the Australian market typically “buy and hold” such names.
But the “buy and hold” strategy does not suit an investor who is looking to squeeze more out of a stock portfolio. More “active”, investors are looking for price discrepancies that suggest one stock is “cheaper” than another and thus offers more upside, and hence profit, potential. Active investors spend more time acting like market “traders” – those who dart in and out of positions in a short time frame – while still perhaps maintaining a core portfolio.
A common argument at present is that National Bank shares are cheap and Commonwealth Bank shares are expensive, on a relative basis. Many also argue that while BHP Billiton is the more solid company, Rio Tinto is offering more immediate upside. Thus an active trader may decide not to hold both NAB and CBA (and Westpac and ANZ) but to play Australian banks just through the “cheaper” NAB, looking for a better return. Or he/she may decide not to hold both BHP and Rio but just Rio, for the same reason.
But as soon as you start getting stock-specific, you introduce a higher level of risk. Is NAB simply cheap for a reason?
Stock market investment is already risky anyway, given we're not always in a bull market. We've just come out of a serious bear market. Yet stock markets are only rarely definable as “bull” or “bear”. Most of the time stock markets trade within ranges – rising and falling over time but not really getting ahead much. The ASX 200 may now be looking at a new high in 2010, but realistically it's been range trading since November.
If you're a “passive” investor, you don't care. Buy-and-holders don't pay much day-to-day attention anyway. But if you're a more active investor, looking to squeeze more return out of your investments, range-trading periods only offer frustration.
Yet while an index might be range-trading, it doesn't mean all the stocks within that index are range trading quite as distinctly. Individual stock movements can still be pronounced. This is a time for “stock-pickers” – those who can identify undervalued stocks which are expected to “re-rate”. But stock-picking usually involves identifying some small or micro-cap stock that's about to have its day in the sun. This is not always an available option to the average active investor.
Relativities are another way stock-pickers pick their targets. If I believe Australian banks are a good investment over time, but that NAB is relatively cheap, then perhaps by playing the relativity I can increase my return without overly increasing risk. Realistically, the least risky way to play relativities is to do so from both sides.
Short selling is usually a dirty word among average investors because the term conjures up all sorts of negative images. Indeed, there are “evil” hedge funds out there who like to trash stocks by selling short. But short selling can also be used in a far less sinister way. Take the futures market as an example.
In any given futures market, no matter what the underlying contract (be it an index, an interest rate, a commodity or whatever), the number of short contracts always matches the number of longs. Futures contracts are not listed like shares, they are simply “created” when two consenting adults agree to trade – one is the buyer, and the other the seller. The seller did not have anything to “sell” in the first place – he simply expects the price of the underlying contract to go down rather than up, while the buyer is of the opposing view. The seller “sells” futures, and in so doing receives the value of that sale as a credit (net of costs). The underlying contract does not have to be “borrowed”.
Or it may be that the seller does not necessarily think the price is going down, but rather he is worried that it might. He then sells futures contracts to “hedge”. A hedger is not, thus, some sort of “evil” short-seller.
So coming back to NAB, what if we hedged our risk of buying by simultaneously shorting the supposedly expensive CBA? We no longer have a “long bank” or even a “long stock” position – we simply have a relative trade between two stocks whose prices are out of whack. This is called “spread trading” or “pairs trading”. Spread traders attempt to squeeze out extra returns without increasing risk.
Spread trading is most prevalent in futures markets where costs are minimal. Spread trading in stocks is more costly because the “short” stock needs to be borrowed and your average clearing broker is not always keen on letting you go short. However, for the slightly more sophisticated investor, these problems can be largely overcome by trading not in the stocks themselves but in equivalent “contracts for difference”, or CFDs. CFDs provide the leverage to exploit incremental price discrepancies over time, and thus allow spread traders to profit without elevated risk.
I'll now pass the microphone over to Jay Richards, a spread trader-broker with Aliom Futures. I shall return later to wrap up.
An Introduction To Spread Trading
By Jay Richards, Aliom Futures
In the last few years, the stock market has (once again) proven not to be a safe haven for investing. It is important to know that the very nature of the stock market is one of capital-intensive investment. It has a bias of “buy low and then sell only when higher”. Of course this means valuable equity will remain (tied up) in the stock market without any capital return while it ranges from a high to a low – known as consolidation. It is generally believed that the stock market is not trending or is in consolidation around 80% of the time. Traders are always seeking ways to produce sustainable profits without staggering draw-downs and prohibitive costs. In recent years, trend-following systems have produced below average returns; day-trading in stock indices and foreign exchange have offered sporadic moments of trading opportunities, but overall have offered up low volatility and choppy markets. Option writers (sellers of premium) have had good returns but will most likely fail when volatility unexpectedly returns.
Within the balance of these trading strategies is an often ignored and largely unknown (outside the professional market) approach called spread trading. In all cases, spread trading attempts to capture the price differential between two contracts. For the benefit of beginners, spread trading is when you buy a futures contract and sell a related futures contract at the same time. When you do this you are trading the difference or spread between the two contracts. The most popular type of spread trading is called the calendar or intra-market spread, which means identical contracts are purchased (one leg long/the other short) with different expiration times; for example, long July – short December corn.
The second type is inter-market spreads which are closely related markets but with identical expiration times; for example, long June hogs and short June live cattle. Another example is long gold and short silver. Let’s say gold is US$1,000/oz and silver is US$20/oz. As a spread trader you might have the view that when gold and silver reach a (price) ratio of 50:1 the spread price is too narrow (historically) and that it should widen out to say 55:1. There is no view or expectation of whether gold and silver will move up or down in price – the spread trader is neither bullish nor bearish either metal necessarily. To benefit financially a trader can buy US$100,000 of gold and sell US$100,000 of silver (using 100 ounce futures contracts). Equal amounts of money are applied (for parity) and as the individual markets oscillate up and down or even trend in the same direction you can profit from one outpacing the other. After a while you note that the ratio (gold to silver price) has moved out to 55:1; both markets have moved lower in price, for example gold is now US$950/oz and silver is US$17.27/oz. The 100 ounces of gold bought at $1,000/oz is sold at $950 /oz (worth $95,000) amounting to $5,000 loss; the 5,000 ounces of silver sold at $20/oz can be purchased back at $17.27 amounting to a $13,650 profit. The net difference is $13,650 – $5,000 = $8,650 profit. The silver price outpaced the gold price.
It is important to recognize the features and benefits of spreads, and here are a few examples:
Greatly reduced margins (as much as one-tenth the margin required for an outright futures trade);
Reduced volatility (as opposed to holding an outright trade): spreads are a natural hedge;
There are more spreads to choose from than actual outright trades;
You inherently become a position trader (the most successful traders are position traders);
You can plan spread trades several days in advance.
Spread trades trend more often while outrights are moving sideways (consolidation) and provide an opportunity to collect profits when the market is range-bound. Let’s have a closer look at this situation.
There are many stock analysts who at present see 2010 as a range-trading environment for stock markets. I will now introduce this concept of spreads to the stock market. In this case I have selected two closely related stocks Commonwealth Bank and National Australia Bank – both are Australian banks (same industry sector), both are listed on the ASX and both are in the top four of most highly capitalized banks.
Similar to the spread example for gold and silver is the example of CBA and NAB shares. The basis for the spread is the historical price relationship and statistical correlation (as evidenced by the similarities noted above) of the two stocks. A spread trader will monitor the two (similar) stocks looking to buy the oversold stock and sell the overbought one at the same time. Just as with gold and silver, similar stocks tend to move in the same direction. Due to the large pools of emotionally-charged investors buying and selling, these shares can experience (price) divergence and create price inefficiency. When this occurs hedge funds and institutions (recognizing an opportunity to profit) step in and take advantage of the price disparity. Holding long and short positions in equal amounts greatly reduces their market exposure and makes the correlated stocks more predictable than holding an outright position in either one of the stocks. There is no view or expectation of whether CBA or NAB will move up or down in price – the hedge fund is neither bullish nor bearish either stock.
As a retail investor, let’s say we apply $10,000 to CBA shares and an equal $10,000 to NAB shares. Determining which share to buy and which to sell is step one; the next is step is to identify a range-bound period (consolidation); and third step is to identify when to establish the trade (the trigger). This is the basis for any sound trading decision. To do this we must first reset their price relationship as 1:1 (since we are applying equal capital to each*). This makes the evaluation simple and can be accomplished with most charting applications. Also, you can use delayed or end-of-day data which is a big cost saving. Below is the side-by-side (overlay) chart of CBA and NAB:
*[A spread uses an equal dollar amount long and short to achieve the 1:1 relationship, not an equal number of shares. Thus to appreciate the movement of each stock in spread terms we must first multiply the trading price of each stock by the number of shares we bought/sold. The next chart exhibits such a relationship.]
If you apply basic bar chart recognition to the actual share price differential, by seeking daily reversals (in which a stock price's high/low for the day exceeds the high/low of the preceding day with a corresponding higher or lower close), you will be more able to easily identify spread trade opportunities for these “pairs”. A differential price near or approaching the horizontal lines represents potential price inefficiency as described earlier. The concept is also known as “buying cheap and selling dear” in spread terms.
The chart below is the spread price (differential) for CBA share price minus the price of NAB shares. If CBA shares are $58.05 and NAB shares are $27.5, for example, they will show as a $28.95 spread price on the right hand axis of the chart.
Looking at a recent trade opportunity on 18/01/10 (daily reversal) we would have sold CBA and bought NAB shares anticipating the spread price to narrow. We anticipate that there is at least a two week holding period (to enter and exit the trade) with margin at 5% on both legs. With this in mind, let’s apply the retail cost for this trading strategy using CFDs.
We entered into the spread trade at 30.55 (closing price 18/01). As the spread narrowed to the “cheap” side of our established range we look to take profit at 27.35 (the closing price on 05/02). Since we have equal equity ($10K) on both sides of the trade we can net out the difference:
We sold $10K worth of CBA shares at $58.05 = 172 shares (value) using a CFD.
We bought $10K worth of NAB shares at $27.50 = 364 shares (value) using a CFD.
We bought back 172 of CBA at 52.65 (short from 58.05) and sold 364 of NAB at 25.30 (long from 27.50). This equates to $5.40 point profit in CBA x 172 = $930; $2.20 point loss in NAB x 364 = $800.00. The net trade profit was $130.00. The cost (using CFD’s) was $83.10. The net profit was $46.90.
[That's a return in two weeks of 56.4%. However, we applied $10,000 to each side of the trade using CFDs. To achieve a 56% return which actually equates to a lot of dollars, we have to increase the dollar value of our two legs. While the risk is greatly reduced by being simultaneously long and short, the CFD provider would need to be appreciative of the trade and the of the investor.]
Now let’s examine the same strategy using futures contracts in this case the June 2010 Eurodollar (interest rate) minus the June 2011 Eurodollar. As with our chart for CBA / NAB we can identify a trading range and daily reversals.
The (margin) cost for this trade is $650 with no on-going holding costs. Since they are identical contracts the price differential is always $25 USD per point. The (typical retail cost) commission is $70 USD (in total) for all four legs. The most recent trade opportunity was on 4/03 where we bought 1 June 10 and sold 1 June 11 contract as a spread. Again, we acted on the daily reversal and it was on the ‘cheap’ side of the trading range. We anticipated this spread to widen. This was a recent trade taken and it made 11 points by holding a long position from 1.15 and selling at 1.26. An eleven point trading profit was made ($275 USD) less the $70 commission = $205 USD net profit.
For the retail investor spread trading in shares has two main differences to futures; one is variation in price per share and the other holding costs. However, spread trading in shares does provide similar risk reduction as spread trading in futures when using traditional calendar spreads. Spread trading with futures has less cost through lower margins; lower commissions and (using calendar spreads) potentially lower risk.
Epilogue
By Greg Peel
Spread trading in futures offers up a whole world of possibility for the active investor looking to engage in low risk, incremental return trades to enhance profitability. Spread trading in futures can be conducted at very low cost.
Spread trading in stocks via CFDs is more costly, but by the same token spread opportunities can offer wider price discrepancies across a whole range of risk profiles. In the above example, Jay used a CBA/NAB spread. Not only are these two stocks in the same sector, they are both Big Four banks. A similar risk profile would be achieved in trading Rio against BHP, for example.
Or you could increase the risk. Perhaps you might consider a “cyclical” consumer discretionary stock against a “defensive” consumer staple, such as JB Hi-Fi versus Woolworths, for example. A classic Australian trade is to switch between banks and resources, and back again. Perhaps BHP versus CBA is a play here. Or maybe you could play the healthcare sector against the engineering sector, in some shape or form.
In each case, you buy one stock and sell the other. That cancels out – to a varying degree – your “market” risk. But the more "different" your two stocks are in your spread trade, the greater the individual stock risk you introduce. The trick is to look for patterns – price movements of two stocks which ebb and flow in relative terms with a level of reliability.
That is not suggest there is no risk in spread trading at all. Spreads can always run against the trader and periods of high volatility can break patterns. One-off surprises (such as a takeover for example) can throw spread prices into chaos. The successful spread trader looks to pick up incremental profits on a hit-and-run basis without over-exposing to risk.
And as noted earlier, the average investor will need to trade stock spreads through a CFD provider who is sympathetic to the intention of the trade (and yes, they do exist).
FNArena intends to bring spread trade suggestions to the attention of subscribers hereafter on an irregular basis. If you would like to know more about the features and benefits of spread trading you can contact Jay Richards at Aliom Futures in Sydney at (02) 8246-8541 or jrichards@aliom.com.au.
Jay Richards is a futures trader and advisor with 20 years experience first at the Chicago Board of Trade and later at the Sydney Futures Exchange. Jay has acted as floor trader and local member specializing in agricultural and interest rate spread trading, has made markets in Chicago Mercantile Exchange forex arbitrage and CBOT interest rate swaps, and has managed trading desks. Jay has also designed and presented a range of trading seminars.
