Yesterday we looked at the spread and how it cut volatility in an otherwise very strong directional market. The spread itself was flat when all the contracts were off about 7 points.
Today, we’ll look at how to trade that spread courtesy of my friends at Moore Research Center, Inc (MRCI).
Long Dec Cotton (CTZ1)
Short May Cotton (CTK1)
Jerry Toepke at MRCI has done some backtesting and showed that over the last 15 years, had you bought December and sold May, you would have made money in 14 of those years. This is a two month spread trade from February 22 and you take it off on April 22. It is saying that the chart I put up yesterday is at it’s narrowest seasonally, and it will widen.
Here’s a look at the chart:
(click for larger and clearer chart)
A few other salient points to make:
The worst drawdown per single spread was $2,090 back in 2005, which was the only losing year. This spread model has the unique characteristic of being accurate and having positive mathematical expectation. The average profit from this spread over the last 15 years has been $971 per spread.
Looking at the entry prices, it doesn’t seem to matter whether cotton was a carry-charge market or one that was in backwardation in order for this spread to be profitable.
You can see in the graph that the solid black line is the current market. This is the same chart I put up yesterday.
Keep in mind that you are not trading the direction of cotton, but the direction of the differences between the two contract months. This is a relative value trade.
Can you count how many way you can win if you need the spread to increase (widen) in order to be profitable?
Chart and data used with permission courtesy of Moore Research Center, Inc. (MRCI).
Trade futures and spreads at your own risk. You can lose money trading spreads. Although it’s never happened to me, both legs of the spread can go against you.
As I mentioned in the blog post, it doesn’t seem to matter which of the two
contracts were trading at a premium to the other. What is compelling is what
happens to the cotton industry this time of year and what everyone does to
the May’s and the Decembers between 2/22 and 4/22.
The spread is now around 75 points. Where do you expect it to narrow to?
According to MRCI, this is a spread that profits when it widens, not
narrows.
If you want the spread to widen your positions should be reversed, long may 11 and short dec 11……
that’s incorrect, but it’s easy to get confused. Your basis is the deferred
month (Dec), not the front. Someone who put this on wants the spread to
become more positive. As it does so, it is said to be widening. If the
spread goes from -60 to -80 it is narrowing because it is becoming a smaller
number. As it become more positive (close to zero) it is said to be
widening.
That was an important post to clarify things. Where do you expect the spread to widen to?
I don’t have any expectation about this trade. It’s not my research…I just
use it to teach about spreads. These aren’t trade recommendations. According
to MRCI, the average profit over the last 15 years has been $975 per spread
by unwinding it on or around April 22.