Trend Followers & The Widowmaker

The Natural Gas spread known as the Widowmaker has been getting some press recently in the WSJ and in Bloomberg/BusinessWeek, but unfortunately for you the reader, it has been plagued with poor writing. The WSJ ran one called Hedge Funds Whipsawed By Gas Bets, which I’ll dissect for you here.

Not two paragraphs into the article, the authors “anchor” you by stating that “Morgan Stanley Smith Barney clients invested in a $640 million group of funds that have emerged as some of the biggest losers in the turmoil. Hedge funds known as “trend followers”—which chase market movements, rather than making fundamental investment decisions —also appear to have been hurt on bad trades.”

By mentioning the losses, you are anchored into thinking that these clients lost a lot of money, which is not necessarily the case. Trend Followers don’t chase either: they spend most of their time waiting for their buy and sell stop orders to get hit since most markets do not trend most of the time.

Trend Followers, if they even trade spreads, were likely long the spread, not short the spread. Most trend followers trade individual contracts directionally — that is, they are either long natural gas or short it. Two, Trend Followers as a group are technical traders who don’t make “bets” based upon fundamental data…that is the realm of hedgers for the most part.

You want to sell the spread when it narrows or lessens, or becomes more negative. Conversely, you want to own something that will increase in value. This particular spread is one of several natural gas spreads that are highly liquid. You adjust the position size for the very volatility that the articles mention. The 20-day Average True Range (ATR) for the March 2001 contract is about 12 cents and it’s about 10 cents for the April 2011 contract. The ATR is a measurement of volatility. In the case of this spread, and in all spreads, you’re long one volatility and short the other.

click to enlarge

As you can see, the spread weakened a full 30 cents or $3,000 per spread from $0.45 to $0.15. Then it formed what looks like an inverted Head and Shoulders pattern, which can indicate a change in trend to the upside, which is the case here. I’ve applied Victor Sperandeo’s 123 Trend Reversal rules because anyone can use them and they are easy to understand. The breakout to the upside occurs at $0.20 and then the spread goes parabolic.

My guess is the WSJ is looking for some headline grabbing, but to a trained eye, the writing is poor. It took the spread approximately 4 WEEKS to move a total of $0.03 or $300 per spread from May 7 to June 7. A trend follower such as myself would never have been short once the downtrend was broken, in fact, one might have been long at $0.20.

March/April 2011 Weekly Chart (click to enlarge)

I’ve written about the March/April before in John Arnold & The Widowmaker back in November 2009 and this past January for the Huffington Post in Portfolio Heat: Brian Hunter Manipulated Natural Gas.

The March/April (of 2007) spread collapsed approximately $2.50 or $25,000 per spread.

The following year’s expiration, the 2008 March/April spread narrowed $1.40 or $14,000 in approximately 5 months. Had you been short, you could have captured any or all of this move. You can trade these spreads many years out on the calendar. Hunter traded against the trend. If he made a bet, it was that the trend would reverse.

To trade something very volatile, keep your positions small or use options to limit your losses.

Any commodity future contract can become a Widowmaker if you want it to. All you have to do is like Brian Hunter did with the “more-on” strategy: trade big in one contract and use a lot of leverage. When it goes against you, you put “more-on.”