One of the interesting things about spread trading is that simpler forms of technical analysis often work quite well. Those that have been trading outright shares or futures for sometime will know you cannot have too much faith in basic things like breakouts and patterns.
Breakouts for example can often be false as the pros see them as a good time to pick off the stops set by the lesser experienced traders. Technical patterns such as triangles and channels just do not seem to work as well as they used to.
With spread trading, it can be a little different. These basic methods of technical analysis tend to work a little more often and therefore provide a more reliable signal.
Today we are going to talk about managing a stop loss on a spread trade using simple technical analysis.
For those not familiar with spreads, there are two basic types:
· An inter-market spread where you trade one market versus another. Going long Soybeans and short Corn is an example.
· An intra-market spread where you trade one contract month versus another in the same market. An example is being long November Soybeans and short September Soybeans.
The key issues with a stop loss, whether it be it for spreads or outright shares or futures, is where to place it. For spreads I have a few simple rules to follow. It makes planning a trade very simple and following it even simpler.
Average True Range (ATR)
Most technical analysis software packages will have the ATR on the list of indicators. The True Range indicator is the greatest of the following:
· Current high less the current low.
· The absolute value of the current high less the previous close.
· The absolute value of the current low less the previous close.
This measurement is then averaged over a period of time to give a smoothed value. In a sense it is a measure of volatility; how volatile the market (or spread) is trading.
As far as smoothing period goes, the default level is 14 days, but for spreads, I find that a shorter period is better. As a default, I use 10 days.
Below is a chart of the spread between Soybean Meal and Soybean Oil. For those that don’t know, when a soybean is processed or “crushed”, it produces two things: Soybean Meal - used as livestock feed; and Soybean Oil - a common vegetable oil. Futures contracts are available in both. Since they are closely related products, a spread relationship exists and it is possible to trade this.
The chart below shows the dollar value of the spread (Meal minus Oil). A reading of $1000 means the Meal contract is worth $1000 more than the Oil contract. As you can see from the range in which the spread has traded, there is a lot of price movement in this spread – and some good trading opportunities.
Source: eSignal Pro
This chart also shows the 10-day ATR indicator with a current reading of $365. Remember this is an average of a single day’s range in the spread. To set a stop value, I use a multiple of this average, normally 3-4 times.
For example, let’s say your analysis tells you the market is well oversold and the bounce seen in the last few sessions is going to continue. With the spread last at $326, you buy it (for the spread this means going long Meal and short Oil).
To calculate your stop amount, multiply the ATR reading of $365 by say three times: $1095. The stop loss level therefore is $1095 below the entry point of $326, or a spread price of -$769.
Spread quotes: For those new to spreads, it is easy to get confused with the way spreads are quoted. In this article we talk about a spread price that is negative. It seems illogical for something to trade at a negative level, but this is simply a matter of how spreads are quoted. To calculate a spread price, one calculates the different between one contract and another. Example: October: | $656.00 | August: | $650.00 | Spread: | +$6.00 |
There are a couple of different ways brokers and traders will quote spreads. A common and understandable way is to subtract the short contract from the long contract. So with the above prices, if you were buying the October contract and selling the August contract, the spread price would be $656-$650= +$6.00. If however you were selling October and buying August , the spread price would be $650-$656= -$6.00. This explains how a spread price can be negative. It is simply the way the spread is quoted or displayed. A negative spread simply means the short contract is worth more than the long contract. When it comes down to it, spreads are very easy to trade and offer some great opportunity. Once you learn the basics such as the way things are quoted, things look a whole lot easier. |
Previous support/resistance
Another consideration when looking at stops is recent highs and lows. As a general rule, I would not set at stop just below a recent high or low. In our Soymeal versus Soyoil for example, the spread recently hit a low of -$388.
In this instance, setting a stop at $400 for example would be too close to this level. Sometimes markets have that annoying tendency to take out a previous high or low then reverse. Setting stops too close to recent highs or lows then could mean taking a loss then watching the market turn and move in the way you had hoped.
Case in point is our Meal versus Oil spread. Moving a few sessions forward on the chart, you can now see the market fell from $326 and just took out the previous low of -$388, making a low of -$500. After this, the market reversed and moved higher.
With a stop based on three times the ATR at -$769, this one would not have been stopped out and therefore would have benefitted from the subsequent rally.
Source: eSignal Pro
It is good to use recent highs or lows as reference point, but make sure your stops are not too close.
In the next article, we’ll look at fine tuning the concept of stop losses including intraday levels, adjusting and contract allocation.
