Introduction to Spread Trading presented by Jay Richards

1. Introduction to Spread Tradingpresented by Jay Richards ‘Trading with a Built-in (H)edge’ www.justspreads.com.au

2. What is Spread Trading? 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 price between the two contracts.

3. What is Spread Trading? By combining a long and a short position you create an entirely new trading entity/contract. - one contract can have multiple combos - different fundamentals at work - indifferent (usually) to the direction of the underlying The new spread has the same charting characteristicsas an outright contract with an ‘Open’, ‘High’, ‘Low’ and ‘Settlement’ price. 3

4. What is Spread Trading? The new spread has the same charting characteristics... Why is this important? Everyone here is a chartist or a technician of price movement! - finer more accurate detail - chart analysis - identify patterns i.e. continuation, reversal, consolidation - apply technical studies 4

5. Composite of a Spread Chart December 2010 corn price is 4.88 July 2011 corn price is 5.09 The price differential or spread price is 4.88 minus 5.09 =-.21

6. Spread Chart of December 2010 Corn/July 2011 Corn

8. Types of Futures Spreads Intra-market or calendar spreads: identical contracts with different expiration times. e.g. long December 2010 and short July 2011 Corn Inter-market spreads: closely related contracts but with identical expiration times. e.g. long August Live Cattle and short August Lean Hogs Inter-exchange spreads: related contracts at different exchanges. e.g. long July Wheat at CBOT and short July Wheat at KCBOT

11. Futures Spreads Terminology Spreads are either positive or negative. The front leg determines this by either being higher or lower in price to the deferred leg. It’s simple math but important to know the terminology. If you buy AUG Cattle (108.925) and sell AUG Hogs (94.825) you will want to see the spread price widen. If you buy JULY CBOT Wheat (6.70) and sell JULY KCBOT (7.910) Wheat you will want to see the spread price narrow.

12. Benefits of Spread Trading • Reduced volatility – spreads are a natural hedge and have less risk than an outright position. Remember the 6% drop overnight in the Nikkei? • Reduced margins – which means that you can afford to hold multiple spread positions. e.g. Heating Oil margin • outright - $5063 calendar spread - $550

13. Benefits of Spread Trading Outright margins / Spread margins Live Cattle $1620 $338 Corn $2363 $270 - $810 Soybean Oil $1688 $101 Crude Oil $8500 $405 - $1215 Copper $5800 $304 Cocoa $2730 $404 13

16. Benefits of Spread Trading • Position trader – as a trend trader (in spreads) you inherently become a position trader. The most successful traders in history are position traders: Warren Buffett George Soros Ralph Nelson Elliott W.D. Gann John Moulton (Rambo)

17. Benefits of Spread Trading True market activity – majority of spreads are not held to the influence of large commercial involvement as with an outright and are less concerned with liquidity and slippage. A ‘natural’ trend will evolve from the ‘merits’ of the spread combination you have selected. 17

18. Benefits of Spread Trading • Trending nature - spreads trend more often than outrights, in fact spreads can trend even while the underlying futures are moving sideways.

19. Benefits of Spread Trading • Seasonal spread pattern – is the tendency for a particular spread to behave (price wise) during a certain calendar period every year. • The monthly chart below ranges from 1995 till April 2011. Close examination will show the seasonal tendencies for this spread to widen during the suggested time frame of early May through the end • of June. 19

22. Benefits of Spread Trading • Greater anticipation – you can plan spreads several days in advance and do not need a technical indicator such as a stochastic or MACD to trigger you into the trade. • If I had eight hours to chop down a tree, I’d spend six hours • sharpening my axe. - Abraham Lincoln

23. Discover Your Comfort Zone Set achievable goals for financial gain Write down your financial goals Establish time frames for each goal Do not trade with any money you cannot afford to lose “An investment in knowledge always pays the best interest.” 23

24. Discover Your Comfort Zone • Discover your comfort zone • Two types of participants: • - traders looking to improve • - those wanting to become a trader or a more active investor • “Be honest with yourself and be patient with the markets... wait for your bus” 24

25. Discover Your Comfort Zone • Speculation is not the same as gambling • - Gambling creates risk on your money • - The risk in trading already exists • Speculators stabilize markets by creating • liquidity and price efficiency • If you rely on hope you are gambling • You must be able to move on from every trade (winners and losers) so you can be prepared for your next trade opportunity. 25

26. Build a Trading Mentality • Be prepared and always a student • Self-determined • “Best fit” scenario – an hour per day • Simulate trade scenarios (paper trades), stay involved through seminars, trading groups and study • Understand a range of markets and their fundamentals • Charts, data and ‘getting behind the wheel’ 26

27. Build a Trading Mentality • Develop your trading style – what works for one trader does not necessarily work for another • Three key points to consider: • The most successful traders are trend-traders • Decide if you will be a day or position trader • Determine your understanding of success • “Our lives improve when we take chances – and the first and most difficult risk we can take is to be honest with ourselves” 27

28. Build a Trading Mentality • Trading Pitfalls: • 1. Failure to have a trading plan • 2. Improper money (trade) management • 3. Unrealistic expectations • 4. Failure to use STOPS • 5. Lack of discipline is a lack of faith in your • decision- making process 28

29. Build a Trading Mentality • 6. Trading against the trend or trying to pick tops • and bottoms • 7. Holding losing positions too long • 8. Over trading • 9. Failure to accept responsibility for your own • trading decision • 10. Not keeping perspective 29

30. Psychology of Trading • Put ‘yourself’ in the role as a trader – stay • within your comfort zone • Allow trading to be a ‘Zen Thing’ • Clear your mind of greed and fear • Practice healthy routines • “The difference between a rut and a groove is attitude” 30

31. Psychology of Trading • Try to improve yourself everyday and enjoy the • journey. Practice your craft and don’t focus too • much on profit or losses. • Allow yourself to ‘feel good’ regardless of profit • or loss, so long as you acted to your plan. • Listen to the market. Think about ‘where your • head is at’ during a trade and consciously • develop the zone that allows you to trade well. • “Do the right thing… regardless of what others think” 31

32. Psychology of Trading • Winning and your ego can create powerful • emotions that distort reality. The more you win • the better you feel and your ego takes over. • The joy of winning is what gamblers seek. • A gambler will lose as many times as necessary • just for the thrill of winning once. • Research, learning and the preparation for taking • a trade takes much longer than executing and • watching a trade. • “Be ruthlessly realistic when it comes to your finances” 32

33. Money Management • Money management is the most important aspect • for successful futures trading. • Although your decision-making process or basis • for taking a trade can be sound, it is your money • management that will make or break you. • You will have a higher number of losing trades to • winning trades. Successful traders know this. • A few winning trades will outperform all the • small losses. • “Accept the fact that regardless of how many times you might • be right, you will sometimes be wrong” 33

34. Money Management • A trading plan is all about mapping out your • expectation - how and when to enter and exit • a trade before you take the trade. • You must create an expectation and believe • in your work. You must have faith in your • decision-making process. • Know precisely how much money you can • afford to lose and use your stop. • Go with the trend. Buy strength and sell weakness. • “Tell me once and I’ll forget; show me and I may • remember; involve me and I’ll understand”. - Confucius 34

35. Spread Trade Opportunities • When we return from the break: • Strategies for taking the Gold/Silver spread • - Spot market in a margin account • - Futures • Pairs trading with ASX shares using CFDs • - CBA/NAB • - BHP/RIO • Trading method for entry, exit and price projection • - Live Cattle futures spread with a seasonal time frame • - Unleaded Gas spread without a seasonal time frame 35

36. Spread Trade Opportunities • Two strategies for taking the Gold/Silver spread • Scenario #1 - OTC trade using spot metals - 33:1 ratio • Our example is based on Gold at $1500/Silver at $45 ounce. • - Customized to your risk appetite • - Margin account let’s you choose the dollar amount • - E.G. $30,000 to each leg (long gold/short silver) • - 20 ounces of gold/660 ounces of silver • - Holding cost is around $5.00/day (not including commissions) • - Requires less than $5,000 • - 5 weeks later spread moves out to 37:1 • - Gold is now $1400/oz; Silver is $38/oz • - We lose $2,000 on the Gold/$4700 profit in Silver • Approx profit is $2700 36

37. Spread Trade Opportunities • Two strategies for taking the Gold/Silver spread • Scenario #2 – Futures contracts at COMEX • Our example is based on Gold at $1500/Silver at $45 ounce. • - Long 3 100/oz AUG Gold/short 2 5,000/oz SEP Silver • - Spread margin is excess of $17,000 • - No holding charges • - 5 weeks later spread moves out to 37:1 • - Gold is now $1400/oz; Silver is $38/oz • - We lose (approx) $30,000 on the Gold/ (approx) $70,000 • profit in Silver. Approx profit is $40,000(less comm) • We look to sell silver the “expensive” commodity (as it relates to gold) and buy gold the “cheap” commodity (as it relates to silver). 37

38. Spread Trade Opportunities • Pair #1 –ANZ/WBC 38

39. Spread Trade Opportunities • Pair #2 – RIO/BHP 39

40. Entry and Exit Strategies for Spreads • Swing Lines to identify specific trends • Bar Chart analysis to trigger us into/out • of trades i.e. reversals, double bottoms/tops • Price Projection based on our swing lines • for a calculated approximation for price • Seasonal statistics provide further • expectation of price behaviourduring a specific • time period 40

43. Entry and Exit Strategies for Spreads Swing Line Calculation for Price Objective Recent swing high#2 is -0.75 Recent swing low#1 is -1.40 The difference is -0.65 i.e. -1.40 minus -0.75 = -0.65 By adding this (-0.65) to -1.40 we can approximate a price objective of -2.05 43

45. Entry and Exit Strategies for Spreads Swing Line Calculation for Price Objective Swing high #3 is -1.8 Swing low #2 is -3.0 The difference is -1.2 i.e. -1.8 minus -3.0= -1.2 By adding -1.2 to -3.0 we can approximate a price objective of -4.2 45

47. Entry and Exit Strategies for Spreads - bar charts improve entry/exit levels - swing lines for trend determination - price projection to bolster our price expectation and maximize profit - trade management is greatly improved with measured expectation A single trade made a profit of $720 47

48. SEPTEMBER/NOVEMBER Unleaded Gas 48

49. SEP/NOV Unleaded Gas Swing Line Calculation for Price Objective Swing high is 1129 Swing low is 932 The difference is 197 i.e. 1129 minus 932= 197 By adding 197 to 1129 we create (project) a price objective of 1326 49

50. SEP/NOV Unleaded Gas Review of our second example we have: - reduced volatilityof around 90% - reduced marginof around 90% outright margin$5,063 spread $550 - no seasonal time frame - bar chartshave double bottoms and reversals to improve entry/exit levels 50