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Futures Lab: Spread Arbitrage is a little understood managed futures strategy when compared to the predominate trend following strategy, but offers interesting diversification possibilities.

Wednesday, November 16, 2011

Understanding Spread Arbitrage Strategy Drivers

Professional investors might be familiar with the managed futures trend following strategy, which generally operates by identifying a market price trend after it occurs, according to Michael Covel, author of the book Trend Following.  However, a less obvious category of managed futures investing can be found in spread arbitrage programs, a strategy with fewer CTA participants that generally operates based on price relationships between related products, as outlined in the book The Complete Guide to Spread Trading by Keith Schap and The Encyclopedia of Commodity and Financial Spreads by Jerry Toepke and Nick Colley.

Strategy Tactical Operation: Spread arbitrage programs are those in which a trader buys one commodity and sells another contract of a related commodity or time frame to capitalize on a discrepancy in prices.1  For instance, a spread arbitrage program my sell (short) the September oil contract and purchase (long) the December RROB gasoline contract.   In this case, the goal is that the short September oil contract falls in price and/or the long December gasoline contract rises in price, which may or may not occur.  

Macro Market Environment Influencer: Spread arbitrage programs are typically influenced by market environments that feature price dislocation and related convergence back to a mean.1  Spread programs may benefit when they properly identify the price dislocation and then the market ultimately reverts back to its mean.  “The mean reverting property is true in spreads,” noted former Chicago Board of Trade economic writer Keith Scahp in his book The Complete Guide to Spread Trading.1  One strategy risk is that prices dislocate and then do not revert back to the mean, which is where risk management comes into play.

How to Understand a Managed Futures Strategy and Related Risk Factors

One effectived method of understanding a complicated topic is to first understand it at a very high level. Once the key concept is generally understood, then drill down and examine the more complex details. Thus, in managed futures it can be instructive to first understand how a basic strategy operates at a high level, recognizing how a macro market environment influences performance and risk, then apply this basic knowledge as an overlay for understanding what can be very complicated individual managed futures strategies and their individual risk considerations.

The Math Behind Spread Arbitrage

In order to understand how a strategy can be uncorrelated to the performance of equity markets and properly assess risk in an investment, professional investors might consider the strategic drivers of each investment.

Spread arbitrage programs often determine trade execution through the use of mathematical probability tables that consider relationships between related products, time frames and pricing and may benefit when prices of related products temporarily dislocate but then revert back to the mean.1  “Spreads can trade higher or lower than a mean, but, in the normal course of events, they work back to a mean.” Schap wrote in his Spread Trading book, highlighting the core strategic driver of the strategy.

Spread Prices Can Widen and Contract In Trend Trading Behavior

Spread price variance, like outright markets, have been known to trend in price, dislocating from a price mean and potentially reverting to that mean (see related comments by Emil van Essen in this issue’s “manager profile”).  “One (contract price) can be trending in one direction, while another trends in the other direction,” noted Schap in his book.  In effect, spread trading can be subject to price momentum and persistence, just not in outright markets but rather in price relationships between contract months or related commodities. 
Spread arbitrage programs “have a basis in the economics of the markets involved,” Schap notes in his book.  For instance, if the value of the front month oil contract is below that of the back month, this might indicate markets are expecting oil prices in the future to rise in price through increased anticipated demand or reduced supply.  This “contango” occurs when a futures contract is higher in price the further it is from expiration.  It is sometimes used by economists to determine the strength of economic activity, as spread prices often exhibit movement from contango to backwardation on each leg of the trade.2  Backwardation is the opposite, when the near futures price close to expiration trades higher than the back month away from expiration.

It is important to note that the spread trade might rely on one “leg” of their trade to revert back to the mean of its normal price relationship while the other leg remains relatively consistent in price, which is sometimes utilized by program managers with the goal to provide protection against exposure to the overall market moves.  For example, the spread program outlined in this example is only a play on the relationship between oil and gasoline, not in the overall direction of the energy market either higher or lower.  Thus, if an outside market force influenced the overall price of the energy market, taking the price of both oil and gasoline dramatically higher, the spread strategy typically does not desire exposure to the overall market move, but rather only the relationship in price between related products.  This is not to say a spread strategy is less risky than an outright long or short position often taken by a trend following program, it is to say that the risks and market environments that influence performance can be different.

“What matters is that both trends responding to the same set of economic drivers,” Schap said, highlighting the importance of strategic performance drivers when evaluating strategies.  “They (spreads) exhibit a structure that responds to economic drivers.”

Strategy Risk Considerations

It is important to note in any mathematical algorithm there are points at which the strategy changes and historically consistent price relationships no longer “work.” One risk in the strategy is when prices dislocate based on historical probability tables they do not revert back to the mean.  This is where the phrase “past performance is not indicative of future results” is provided meaning.

Many economists have indicated that markets are so efficient that such opportunity for spread arbitrage may be limited, while other economic voices, such as MIT’s Andrew Lo, note that while market places may be efficient, decisions of market participants can be irrational – resulting in irrational market price movement.4  Indications are the market environments are constantly changing and risk management is tested when the formula and probability tables no longer apply to a given market environment.  When considering risk, it is also important to note that macro strategy risk is different from more complicated factors not outlined in this document involved with individual manager risk, to which investors should be aware.

Footnotes and additional reading:

  1. A spread trade is commonly defined: An arbitrage technique in which a trader buys one commodity and sells another contract of the same commodity to capitalize on a discrepancy in prices.  Read more:  http://www.investopedia.com/terms/f/futuresspread.asp#ixzz1aoAwd9Lk  To understand various spread trading strategies and how mean reversion market environments impacts spread arbitrage programs: The Complete Guide to Spread Trading, Schap, Keith, McGraw-Hill, 2005; The Encyclopedia of Commodity and Financial Spreads, Jerry Toepke and Nick Colley, Wiley, Jan 3, 2006
  2. Backwardation definition: As the contract approaches expiration, the near futures contract will trade at a higher price compared to the far contract from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk free rate. Backwardation in futures contracts was called "normal backwardation" by economist John Maynard Keynes. This is because he believed that a price movement like the one suggested by backwardation was not random but consistent with the prevailing market conditions.  Backwardation is the opposite of contango, where the higher price away from expiration than near expiration.  Read more: http://www.investopedia.com/terms/b/backwardation.asp#ixzz1asXiI09S
  3. Price Persistence definition: http://www.investopedia.com/terms/p/price-persistence.asp#ixzz1ao4Rvfen. Price persistence is also considered synonymous with price momentum.  For reading on how trend following operates, including the role price persistence and momentum plays a role:  Covel, Michael, Trend Following, Financial Times Press, 2009; Little, L.A., Trend Qualification and Trading, Wiley, 2011. 
  4. For understanding of how markets can be impacted by inefficient decision making, refer to: A Non Random Walk Down Wall Street, Andrew Lo and A. Craig McKinley, Princeton Paperbacks, 1999; The Myth of the Rational Market, Justin Fox, Harper Collins; Why Markets Fail, John Cassidy, Picador, 2009.

 CFTC RISK DISCLOSURE: PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. YOU COULD LOOSE ALL OF YOUR INVESTMENT OR MORE THAN YOU INITIALLY INVEST. IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS. THE DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF THE PRINCIPAL RISK FACTORS AND EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE COMMODITY TRADING ADVISOR ("CTA"). THE REGULATIONS OF THE COMMODITY FUTURES TRADING COMMISSION ("CFTC") REQUIRE THAT PROSPECTIVE CUSTOMERS OF A CTA RECEIVE A DISCLOSURE DOCUMENT WHEN THEY ARE SOLICITED TO ENTER INTO AN AGREEMENT WHEREBY THE CTA WILL DIRECT OR GUIDE THE CLIENT'S COMMODITY INTEREST TRADING AND THAT CERTAIN RISK FACTORS BE HIGHLIGHTED. THIS DOCUMENT IS READILY ACCESSIBLE AT THIS SITE. THIS BRIEF STATEMENT CANNOT DISCLOSE ALL OF THE RISKS AND OTHER SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. THEREFORE, YOU SHOULD PROCEED DIRECTLY TO THE DISCLOSURE DOCUMENT AND STUDY IT CAREFULLY TO DETERMINE WHETHER SUCH TRADING IS APPROPRIATE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. YOU ARE ENCOURAGED TO ACCESS THE DISCLOSURE DOCUMENT. YOU WILL NOT INCUR ANY ADDITIONAL CHARGES BY ACCESSING THE DISCLOSURE DOCUMENT. YOU MAY ALSO REQUEST DELIVERY OF A HARD COPY OF THE DISCLOSURE DOCUMENT, WHICH WILL ALSO BE PROVIDED TO YOU AT NO ADDITIONAL COST. THE CFTC HAS NOT PASSED UPON THE MERITS OF PARTICIPATING IN ANY OF THESE TRADING PROGRAMS NOR ON THE ADEQUACY OR ACCURACY OF ANY OF THESE DISCLOSURE DOCUMENTS. OTHER DISCLOSURE STATEMENTS ARE REQUIRED TO BE PROVIDED YOU BEFORE A COMMODITY ACCOUNT MAY BE OPENED FOR YOU. MUCH OF THE DATA CONTAINED IN THIS REPORT IS TAKEN FROM SOURCES WHICH COULD DEPEND ON THE CTA TO SELF REPORT THEIR INFORMATION AND OR PERFORMANCE. AS SUCH, WHILE THE INFORMATION IN THIS REPORT AND REGARDING ALL CTA COMMUNICATION IS BELIEVED TO BE RELIABLE AND ACCURATE, NOT WARANTEE RELATIVE TO SAME IS AVAILABLE. THE AUTHOR IS REGISTERED WITH THE NATIONAL FUTURES ASSOCIATION.



 
This article was published in Opalesque Futures Intelligence.
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