What is Spread Trading?

Next to options trading, spread trading can be one of the most potentially confusing areas of finance. However, the essence of it is fairly simple. Spread trading means buying a futures contract or other type of security and selling another related one in order to profit from the price difference, or “spread” between the two. This is often done to take advantage of predictable seasonal changes in the price of certain commodities. Investors who use the spread trading technique may study historical or technical factors in determining when and how to place trades and where prices are likely to go.

Spread trading falls into three basic categories, the first one being intramarket spreads. This is the simplest type of spread trade and involves buying and selling the same commodity, but for different months. For example, an investor might buy July wheat and sell December wheat. Intermarket spreads are a second type in which different commodities are traded for the same month. An example of this might be buying July wheat and selling July corn. The third type is the inter-exchange spread, where one commodity is traded but on two separate exchanges. For example, an investor might buy July wheat on the Chicago Board of Trade (CBOT), but sell October wheat on the Kansas City Board of Trade (KCBOT). Inter-exchange spreads are less commonly used than the other two types.

There are many commonly used patterns in spread trading, many of them with nicknames that suggest the commodities involved. For example, a Spark spread is a spread trade between natural gas and electricity, and a Crush spread is a spread between soybeans and soybean meal and/or soybean oil. In any spread trade, an investor or trader must concern themselves with whether or not both sets of prices are moving in their favor. The amount of attention and expertise this requires can make these trades somewhat confusing, especially to an inexperienced trader.

Most securities exchanges do not report spread transactions along with other price quotes, although this practice was once common. To get accurate data on current spread trading, it is helpful to have the assistance of a broker who can contact the trading floor for the latest information. Spread trading can have value for some investors, but the cost of working closely with a broker may be prohibitive for some. This factor, as well as all the costs of spread trading, must carefully be considered by the individual investor.

What is a Trading Range?

The trading range has to do with the difference between the low and high prices associated with the trading activity of a security or group of securities within a given market. There is usually a time frame specified for the trading range. The duration of the trading range may be a few hours, a full trading day, or a full trading week.

There is a small difference between a trading range on a stock market and one that has to do with a commodities market. With the stock market, a range of trading focuses on the spread or difference between the highest price and lowest price recorded during the time period under consideration. The trading range can be used as a good indicator of how a stock is performing within the current economy and general market conditions

In the case of a commodities market, the trading range has to do with the scale of trading prices authorized by the market for the current trading period. Orders cannot be executed unless the price named in the order falls within the range set by the market. The range usually remains in effect for at least one full trading day, although a previous day’s trading range may be issued again at the beginning of the next trading day.

Regardless of whether the trading range has to do with commodities trading or security trading, information regarding the current trading range is very helpful to investors. The details of the range help to point toward other indicators that may influence a decision to buy or sell the security in question. Depending on changes in the trading range from one time period to the next, investors may see a trend developing that indicates purchasing additional shares is worth consideration. At the same time, analyzing the trading range of a security for several successive periods may indicate a developing trend that is not favorable. When that is the case, the investor can take the necessary action to minimize the amount of loss incurred.

What is Currency Trading?

Currency trading is the largest market on the planet. It is estimated that in excess of US$2 trillion is traded every day. Compare this to the New York Stock Exchange's daily transactions of approximately US$50 billion, and you can see that the magnitude of the currency trading market exceeds all other equity markets in the world combined. The practice of currency trading is also commonly referred to as foreign exchange, Forex, or FX, for short.

All currency has a value relative to other currencies on the planet. Currency trading uses the purchase and sale of large quantities of currency to leverage the shifts in relative value into profit.

There are two reasons the relative value of a currency fluctuates. The first is because of a 'real' market: as outside investors or visitors wish to buy things within a country, they are forced to convert their domestic currency into the currency of the country they are buying within. Similarly, as money leaves the country, people must sell their currency for the foreign currency they will need to spend or invest abroad.

The second force for currency fluctuation is speculation. As investors feel a given currency will act strongly or weakly, they will buy or sell accordingly. This speculation can have drastic consequences on a national currency and consequently on a country's economy. During the East Asia Crisis in 1997, for example, as nations in Asia began facing economic downturns, speculators used currency trading to realize enormous profits and in many analysts' view helped to exacerbate the problem.

Currency trading has many very real benefits over equity trading like the stock exchange. The spreads for currency trading are extremely low, making the cost to a trader very low as well. The volatility of the currency market is extremely high, which means that a trader can generate enormous return on a given exchange. The ratio of volatility to spread is approximately 500:1 for the currency trading market, as compared to 100:1 for even the most ideal of stocks.

Until recently, the currency trading market was very closed to small investors. Banking conglomerates and large multinationals were the main movers of this market place. In the past few years, however, new technologies have opened the doors to investors of all stripes. It is difficult to miss the enormous benefit of this 'new' market for the individual investor: higher returns with lower risk given the same amount of market knowledge have a very small downside.

Global stock markets in 2008

he global financial turmoil seen during 2008 has led to extreme volatility on the world's stock markets.

Below you can see how some of the main global stock indexes have fared during 2008 (graphs update automatically).

FTSE 100 INDEX: JAN-DEC 2008

Carry Trade

What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency’s interest rate is greater than the purchased currency’s rate, the trader must pay the net interest.

Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.

How are Rate Expectations calculated:

Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe the market prices influences policy decisions). To take advantage of the collective wisdom of the market in forecasting rate decisions, we will use a combination of long and short-term, risk-free interest rate assets to determine the cumulative movement the Bank of Japan will make over the coming 12 months. We have chosen the Bank of Japan as the yen is considered the proxy funding currency for carry trades.

To read this chart, any positive number represents an expected firming in the Japanese benchmark lending rate over the coming year with each point representing one basis point change. When rate expectations rise, the carry differential is expected to contract and carry trades will suffer.

What are Risk Reversals:

Risk reversals are the difference in volatility between similar (in expiration and relative strike levels) FX calls and put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta. When Risk Reversals are skewed to the downside, it suggests volatility and therefore demand is greater for puts than for calls (as implied volatility for puts is quoted as a negative percentage and implied volatility for calls is quoted as a positive percentage) and traders are expecting the pair to fall; and visa versa.

We use risk reversals on USDJPY as it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader. When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades.

What is the DailyFX Volatility Index (VIX):

The DailyFX Volatility Index measures the general level of volatility in the currency market. The index is a composite of the implied volatility in options underlying a basket of currencies. Our basket is equally weighed and composed of some of the most liquid currency pairs in the Foreign exchange market. In reading this graph, whenever the DailyFX Volatility Index rises, it suggests traders expect the currency market to be more active in the coming days and weeks. Since carry trades underperform when volatility is high (due to the threat of capital losses that may overwhelm carry income), a rise in volatility is unfavorable for the strategy.

US Dollar & US Bailout Bill

The US dollar began a new day on a strong note but afterward pulled back on signs of a deteriorating reduction in the US manufacturing division. The Institute of Supply Management’s (ISM) manufacturing index went down a lot more than anticipated to a estimation of 43.5 in September from 49.9, scoring the most terrible level from October 2001 and the 3rd following month under 50, which indicates a abbreviation in business activity. Examining the analysis of the report, there were some positives. The production component went down in excess of 11 points alone to its most terrible data from February of 2001 whilst new orders and employment pushed to levels not shown from October 2001. The employment section is mainly concerning as US non-farm payrolls (NFPs) is going to be released on Friday and are anticipated to mirror heavy job losses for the 9th following month, the worst run since NFPs went down negative throughout 20 of the 24 months from 2001 - 2002.

EURUSD stays under pressure

Euro-Dollar (EURUSD) stayed under pressure following its extension of its current losses to mark 1.3914 Asian session lows. The dollar maintained solid following the U.S. Senate passed the U.S. bail-out bill; even though gains were comparatively silent after a lot of members were previously placed for a positive result. The real economy is anticipated to return to focus, by the ECB conference due today, where the market is going to seek any posturing on a possible ECB rate cut. We anticipate the focus to stay on inflation in spite of the monetary chaos, even though current sittings have seen bigger conjecture of a move in the ECB posture given the worsening in the monetary markets and the possible impact on the real economy. In the meantime, the European market is seeking a unified European reaction as well to the banking catastrophe, though the separate measures by now taken by European nations up to now might decrease the probability of a wide euro zone olicy response.