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Exercise 4: Spread ‘Em Up
There was something deliberately missing from the relatives exercise. After reading
this page, a few more things might start to make sense.
This exercise is a natural progression from the ‘relatives’ exercise. Here we will
introduce spreads and a tool for analysing relative movement.
We will continue using the Treasury notes and bonds and stick with the trade size
and limits:
Market
Trade size
Max position
3
9
Tnotes
2
6
Tbond
1
Fives
3
The idea with a spread (at least for this drill) is you are long one and short the other.
We refer to each part of a spread as a “leg”. So if you are long the Tnote and short
the Tbond, both the Tnote and Tbond are referred to as legs.
Entering ‘Exchange Spreads’
For most spreadable markets, an exchange will offer a spread market. We call this
an ‘exchange traded spread’. Check out the ‘FastTrack’ course on Exchange Traded
Spreads on this site for a complete explanation. For now, all we need to say is an
exchange spread allows you to trade a spread with one click instead of trading each
contract.
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The net result is the same. That is, you end up long one and short the other. The
exchange spread facility just makes the process easier.
How We Will Do It?
The short answer is we’ll do it the hard way. We will not use an exchange spread.
Instead we’ll “leg in” to the spread. Legging in means to trade each contract
separately. It’s not that hard considering it’s what you’ve been doing with each trade
so far. The only difference in this exercise will be that you will take an opposite
position in a related market.
Relative Movement
If you’re into bond market maths, you’ll know what a DV01 is. It stands for Dollar
Value of a Basis Point. For Treasuries, remember when prices go down, yields are
going up, but by how much?
If the Tnote drops 10/32nds, how many basis points is that? The answer requires
you know bond maths (hard) or you can look it up on the CME website (easy).
I’ll save you the trouble and list them here:
Market
Fives
Tnotes
Tbond
DV01
$48.11
$74.49
$146.07
These dollar figures change all the time based on where prices are. You can get the
latest here:
http://www.cmegroup.com/trading/interest-rates/duration.html
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So What Do They Mean?
Take the Tnote. For every 0.01% change in the yield, the price of the note changes
$79.11. That’s all it means – although you cannot see it in the futures price as
futures aren’t quoted like that.
“Huh?” you say. Yep, they make it confusing, but stick with it as it’s useful to learn.
To make it useful we next have to do a little calculation. We want to know how many
price ticks it takes for yield to move 1 basis point.
The reason we do this is:
We need make the assumption that yields across the three contracts
will move together. When one moves, the other two should move
about the same in YIELD terms.
Is it a fair assumption? Nope, but it’s a starting point for analysis. If you sit there and
compare price movement, it will do your head in. Start thinking about market
movement in terms of yield and in a short while it starts to make sense. (Remember
the Matrix analogy? It works here too.)
So, let’s get back to it. Let’s calculate how many ticks in each of the three market it
takes for yield to move 1 basis point. Remember each 1/32nd in these markets are
worth $31.25 ($1000/32), so the calculation is pretty easy.
We simply divide the DV01 by $31.25 to see how many 32nds it takes to move yield
by 1bp.
Market
Calculation
Result
Fives
$48.11 / 31.25
1.54 / 32nds
Tnotes
$74.49 / 31.25
Tbond
$146.07 / 31.25
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2.38 / 32nds
4.67 / 32nds
So what now? We now have a figure that shows us what we might expect one
market to move relative to a move in the other. If our assumption of parallel yield
movement holds, our three markets will move up and down in the ratio shown in the
table. If we see the Tbond fall 5/32nds (close to 4.67), we’ll also see the Tnote drop
close to 2.5/32nds (near 2.38) and the fives drop 1.5/32nds (close enough to 1.54).
Now this is getting interesting huh? Do you know people actually trade the treasuries
and never learn this stuff? Now you know more than most.
Another example, if I say Tnotes are down 10/32nds, you could assume the fives
and bonds are down how much? Calculate it in your head, then scroll down.
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Did you cheat and just scroll down? Doesn’t matter. All we are doing is working out a
rule of thumb for movement.
The answer: if we see the Tnote down 10/32nds, we know that’s about 4 basis
points. 4 basis points in tick terms for the fives is 6/32nds (4*1.54) and for the bonds
it’s close to 20/32nds (4*4.67).
So that is a long winded but interesting explanation of the rule of thumb we now
have. The rule is for every 2.5/32nd move in the Tnote, we should see a move of
5/32nds in the Tbond and 1.5/32nds in the Tnote. Put that on a post-it next to your
screen if you like.
You can now use this rule of thumb to help spot spread trades. Use to to see if one
market has moved more than it should relative to the others
Hedge Ratios
A hedge ratio is the ratio of contracts we trade in a spread where one should offset
the other.
Have a guess what ratio we use?
It’s the ratio of DV01s! That was easy.
Why do we use those? Remember it’s the assumption that yields will move together
or parallel.
Do they always do that? Not at all. That is what makes spread trades possible. Now
this is getting to the juicy stuff.
Let’s calculate our hedge ratios.
Spread
Name
Calculation
Fives –
FYT( (“fight”)
48.11 / 74.49
Tnote
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What we
will use
3:2
Five –
FoB (”fob”)
48.11 / 146.07
NoB (“nob”)
74.49 / 146.07
3:1
Tbond
Tnote –
2:1
Tbond
So does this look familiar from the last exercise?
Market
Trade size
Fives
3
Tnotes
2
Tbond
1
You now know why we have these ratios.
Really nothing has changed from the last exercise. It’s just now we know that to
spread or hedge, we need to trade in those ratios.
What About Other Markets?
If you’re trading other fixed interest markets, you can use that DV01 method for
calculating a spread or hedge ratio.
An alternate method for other markets (and one we could use here if we felt like it) is
use a ratio of relative volatility. I like using the Average True Range (ATR). It’s
available on most charting platforms.
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Like DV01s, the ATR is always changing so those ratios will always change. For the
treasuries, interestingly they come up with the same spread ratios (once rounded) as
using DV01.
OK, TELL ME THE EXERCISE!!!!
Yep, I get it. I talk too much. That took a long time to explain. However, it’s important
to understand the process and logic behind the ratios.
Now the exercise…
It’s quite simple. Apply the ‘Relatives’ drill but add one simple component.
Offset every trade with a trade in a related market.
If you are going short 2 Tnotes, then buy 1 Tbond or 3 in the fives AT THE SAME
TIME. Don’t do all three. Just take your position in one and had a hedge in other of
the others.
That alone is pretty straight forward. You can choose limit or market orders, but lean
towards limits as much as possible.
Adding Some Complexity
There are always short term movements where the markets do not follow those
exact ratios. For a scalper, that’s the meat in the sandwich. That alone could be your
trading strategy. It takes a lot of work and focus. It’s exhausting and involves a lot of
small tick trades. People however do make a living from this.
HOWEVER, you’ll never hit massive home runs with trades like this. The home runs
come from taking directional positions AND varying that ratio. So there are two
things to look at here.
1. Directionality
That’s where using your charts and technical analysis comes in. You’re not going to
get directionality from DOM.
Adding this element to your strategy will require you keep charts of the individual
contracts on the screen as well as spread charts. For the spread, start with just a
simple cart of one minus the other. One minus the other does not take into account
the spread ratios you will be trading, but it’s a good place to start your analysis. If
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you can, overlay it with a chart in the Tnote or Tbond. Then you’ll see the how the
spread chart moves relative to the underlying.
The rule of thumb is, in terms of dollars, the long end (the bond) will lead the way.
That is why the ATR is larger. It’s a more volatile contract. For the maths buffs out
there, this is all to do with ‘duration’, but that’s not important here.
So to take a directional spread position, you would have your longer end product in
the direction of your view and the opposing position in the shorter end. That means
if:
The market is bearish:
Short
Long
Tnote
Fives
Tbond
Fives
Tbond
Tnote
The market is bullish:
Long
Short
Tnote
Fives
Tbond
Fives
Tbond
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Tnote
You could also put that on a post-it next to your screen, but it will be memorized in a
few minutes as it’s kind of logical.
2. Varying the Ratio
Now this is getting fancy. You can trade more or fewer in one contract to change
how the total position behaves. It sounds complex at first, but it’s not. It’s actually
quite logical.
If you’re long the NoB (long 3 Tnotes, short 2 Tbonds), you could for example
change the exposure by trading a 1:1 ratio instead of 3:2. In this example, it would
have the effect on giving you an even greatershort exposure. You could say it’s a
spread with a short bias.
You change the exposure (bias) by varying the ratio. Don’t over think this. If you put
on more longs, then you’re more long. If you put on more shorts, then you’re more
short.
When to Add Complexity
For this exercise, don’t do it the first time. Have at least a day trading the strict ratios
and keep your positions with a short term focus.
Then, come back and do the exercise over with these variations.
For now, look for relative movement opportunities and trade the spread ratio. Keep
your stops tight and your trades short term in focus.
What to look for in P&L
With strict ratios, what you want to see in your P&L is slow and consistent growth.
The idea is to win a little, lose a little, but win more often than lose. When it’s all
looking nice and smooth, you’re doing it right.
Stop!
Oh, one thing about stops. You’ll notice the spread is more forgiving to your P&L.
That is, you can have the comfort of holding a trade a little longer. It means you can
sit on a trade for half a day. Some scalpers will have a time stop. That is, if the
market is not coming back the way they expect, they are out. This will often happen
on volatile days and ones with larger net changes.
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For this exercise, you’ll want to keep your stops tight, but should also consider
pulling a trade after 5 or 10 minutes, if it’s not working.
Keep analysing here too. You want to develop a feel for when you want to double up
and when you just want to close. Don’t be afraid to experiment with either.
Have fun with this exercise!
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