Martin Kronicle

A great question came in today via email, and I like to answer these publicly while maintaining the Reader’s anonymity. The old adage from the classroom is, “If you have a question, chances are there are many other people with the same question, so ask away.” Question is in RED, and my answer follows.

For risk / market correlation purposes, how many total currency pairs at any given time is allowed before a trend trader becomes too risky?

My approach would be to study the correlations and cut position sizes down to the sleeping point. In other words, it’s the trader’s behavior that is risky, not necessarily the instrument/vehicle traded. IMHO, I trade commodity futures more conservatively than most investors handle their mutual funds: they have no sense of risk management at all. It only STARTS with diversification…

I would also note, if you’re trading the interbank, you pay special attention to the exotics as the spreads can be wide, and they can also be illiquid – which is horrible for risk management when you’re trying to exit the losing trade in particular. Test your model with an obscene skid/slippage figure for those.

Here is a funny and lighthearted quiz on the fundamentals of crude oil. Some of the answers may surprise you – I think that was part of its design.

This shot depicts two things:

1 – there doesn’t have to be a correlation between and ETF/ETN and the commodity it holds.

2 – If you have the institutional mindset of “long-only” and you own assets in futures that trade in what are called contango or carry – charge markets, you will find yourself in a situation where you have to liquidate the front month (cheaper) to purchase the next (higher) month out when you roll the contracts.

Such markets are characteristic of commodities with ample supply and the spreads suggest storage, rather than immediate demand.

Hmm? Curious to see a company such as UNG make such a mistake. They seem to have some educated, and highly intelligent members of their team, however, my guess is none are traders. Click on the graphic below to see it more clearly.

Here is a look at what is called the strip – the prices for each successive contract for the calendar. You’ll notice that for the most part, contract prices increase the further you go out in the strip. (Click on the graphic, and it will open to the full size).

The only way to trade this type of market (carry-charge) would be to implement a spread trade. Unless there happens to be a random spike in Natural Gas prices, you’re out of luck with this vehicle. This would be true for any other commodity as well.

I will write more about how to use spreads in this situation in another post. Please email me if you have something specific you’d like to know.

“Inflation usually starts by the government printing too much money.”