RM: Risk Management
In the world of the commodity futures markets, no subject generates more interest and questions than spread trading. A spread combines both a long and a short position put on at the same time in related futures contracts.
“Spreads should be regarded not as the causes behind the action but the results.”
One insight that I can give you comes from a discussion back in the early 2000’s with a pedigreed trader and team leader at a Top-Tier merchant back in the midwest.
We touched ST and he simply answered my question with this:
“Spreads & basis movements and the markets are “the results”, nothing less, nothing more.”
“The results are the fingerprints of what we do here; decisions to store or move the physical from point A to B, in a chosen time-frame”.
The “What we do here” is simply commodity trading:
Commodity trading : trade defined as shifting the commodities from surplus regions to deficit regions or matching the production with a sale in a deferred time-frame (the curve) – and hopefully making a profit in the process.
Hedging ≠ Speculation, but speculation determines the outcomes of hedging.
Learning the process of spread trading is useful for risk managers too.
If the goal is to hedge for risks, how could you also realize the goal at the minimum net cost ?
However, you RM abilities depends still heavily on your ability to understand speculative movements.
Market timing will always determine the outcomes of the hedging.
Mean Reversion and Spreads
Mean Reversion is very intuitive for anybody coming out from the bell-curve school !
One elegant idea is to use a strong mean-reverting (Co-integration) relationship between two variable before initiating a spread trade.
In the trading world, the nearest thing to this mean reversion concept is just known as range-trade or range-bound trading.
Suppose that you can detect this co-integration relationship with your algorithm it will be probably gone !
No such statistical models can predict the future co-integration between two variables.
Most Spreads are directional. Every non-reverting spreads are directional.
Mean reversion trading is one type of spread trading but in my opinion, it’s often better for a master thesis than for trading markets because markets are too irrational.
Commodities Markets: not an asset class.
According to the CFA curriculum, commodities markets are an asset class.
It is fundamentally wrong to suggest it that a commodity is an asset class. I don’t think that one can invest in commodities, I think that one can trade commodities.
I argue that those treating commodity as an asset class are leaving people down the road on a very ill-advised path.
Nobody that I know invest in commodities, they trade and it’s a totally different mindset.
One tends to buy a commodity during certain times, one will sell another commodities during another time.
Commodities Markets are more like currencies: Traders tend to be long of a commodity and short of another commodity at the same time.
Prices in some commodities markets can be negative, the market can pay you to take the delivery of a commodity. It’s not the condition for an asset class, commodities are a trading-class not
an asset class. Learning Spread Trading is a very relevant skillset for those aspiring to become trader in the commodities trading-class, hedge fund universe.
From my personal observations and recent experiences, the least understood aspect of trading in the medias (include what is taught in the Business Schools) is the Gaming element of the markets.
About the gaming aspect of markets, I’ve found that many people with absolutely no formal education (sometimes High school dropouts) got it much better than very intelligent people with formal education in finance.
One anecdote dated from my time as a Lecturer of Finance at the university is that they have a hard time to understand the long/short universe, flows and flaws in the modern finance.
They would be terrible traders.
In fact both CFAs, academics should probably not trade.
They will do well in the long-only universe (investing) but will be disoriented by the various unknown parameters and irrational movements of trading. (the most relevant examples might come from the commodity markets).
Regrettably, the mood in the Modern finance is to focus on what we know, we don’t worry as we should about what we don’t know.
Why is it fundamentally wrong ?
My tenure as a lecturer of finance in derivative products has revealed me an unexpected pattern.
99% of my students failed in logical problems applied to the real world.
I have been able to measure this attitude in the exams as well.
It remains a big enigma for me and many people: why critical thinking and reasoning skills are so low in our business schools whilst they are the most sought skill set in the real world ? (especially in the world of finance & economics).
It just too early to blame students because there are far more questions than answers.
Are the financiers, analysts and traders better than 30 years ago ?
Some have pointed out that yes.
At the top of the pyramid, it is very possible that today’s analysts are better trained than 30 years ago, but what about their decision-making skills ?
I repeat that in the real world of finance, there is an inverse relationship between trading outcomes over what we think we can control…
The more your focus is on what don’t you know, the more effective is your trading. It’s not clear if the actual trading context( what you know) will be repeatable.
To me the smartest and best investors, hedge funds and traders that I have known since 10 years are critical thinkers that have made their trading dollars with groundbreaking ideas.
The good news is: the field is left wide open for candidates interested in learning for themself.
The bad news is that lack of critical judgment and poor reasoning skills = poor decision-making in the world of finance and trading.
L for Liquidity
Liquidity: describes the total number of buy and sell orders in the waiting line+ how fast they are replenished. When I am long or Short I don’t add nor remove liquidity.
When I enter an order, I add liquidity, and when the order get a filled, ( long or short) I remove liquidity.
It is believed that ST adds liquidity to the market but ST doesn’t necessarily add liquidity to the market. You definitely need liquidity to trade ST.
The Market Depth is often bigger in Spreads quotes than on outright contracts.
There is a type of spread trading which is based on the flows, the liquidity differential between contracts.
Every commodity has a specific, Delivery process. During the delivery process, FUT and spreads become unstable.
In a spread position since you are LONG and SHORT, you still run a delivery risk on the LONG leg if you don’t exit the position before the 1st day of notice.
Daily standard deviations (spot, fut) and daily futures-spot spreads in the delivery month can give an indication of the convergence between physical and paper markets.
The delivery process affects your trading and your Rm.
A Break-point can be seen as an event ahead of the delivery.
ST, Volatility and Correlation.
In low Vol + high corr environment mean reversion and ST generally works very well.
Now for the human behind the machine it is always a different story… (Still Nobody can pretend to predict future vol and corr…)
Outright/Spread Volatility with a naked eye.
Drawbacks of ST in equities and energy.
In Equities, many use the long-short sectors positions and termed it as Relative-Value strategy but where is the relative-value ?
P&L is a function of leverage, hope and pray or relative-value ?
In Commodities break-ups in the volatility and corr are frequent, Quants referred it as the jump process.
Think about a Katrina or an event that cause a total breakdown in correlations.
Think also about the Shale Gas revolution. Many people have deceptively try to predict a reversion to the historical oil-gas ratios.
In Energy: Mean Reversion and Fat tails are extremely important. Seasonality is also important for NG and Power.
For seasonals, a positive premia are attached to calendar months of high demand or low supply.
Institutional Asset Managers;
There are no upper, lower bounds in spread trading and some risks (Liquidity risk, Event risk) have wiped out HFs.
In 1997, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to Robert C Merton and Myron Scholes for their work in determining the value of the derivative products.
We also saw this clearly in the 2007-2010 financial crisis, when a widely used method resulted in massive losses because it ignored the impact of the movement of home prices on CDO valuation.
Risk management must incorporate mean reversion, jump diffusion, seasonality into forward curves or you run the risk to misrepresent the trade book risk over/under estimating risk.
The question is what is the impact of
– A parallel shift of the frwd curve (corr)
– The titling of the curve (slope) (change in the convenience yield, changes in the expected long-term prices.
– A change in the curvatures related to vol of futures prices, long vs short-term S/D expectations. *
*this one is marginal/negligible for commodity curves.
Bloomberg provides good models in NG, Fixed income, CDS. Sunguard’s Kiodex provides excellent independent forward curves for energy.
The next frontier of ST is frwd curves (futures) adjusted for these factors.
The adjusted data and models can improve or change “What you See” in the markets. (especially in energy).
Natural Gas, Power
Natural Gas OTC is a playground for spread trading.
Ex: NG Otc Swap rate– Nymex GAS spread, Basis forward curve for NG delivered at a location, electricity vs heat rate spread otc swap…
For instance utilities typically manage the risk around their retail load by contracting with a rolling frwd hedge profile several seasons ahead of delivery.
Even if OTC contracts are cleared through an exchange such as ClearPort, derivatives are often valued using forward curves that are often
not traded on exchanges. As such, the value of these derivatives depends on the OTC forward prices of these contracts.
In order to independently value positions, it is imperative as a risk manager/trader/investor, to have access to accurate and independent frwd curves and models.
In NG, The discrepancy between the CME ClearPort data and your independent fwrd curves model is often due to the fact that the
exchange data does not provide adjustments for seasonal variations.
You run the risk of misrepresenting your risk, Mark your net asset value accurately but also not trading what you think.
The forward prices shown are for IF Transco Z6 (exchange data) versus OTC voice broker data on the same natural gas location provided by SunGard Kiodex.
The discrepancy between the curves is due to the fact that the exchange data does not provide seasonal variations in winter months.
Suppose that you are Long Winter spreads at Transco Z6 (NG OTC Swap rate at Z6 – Nymex Gas Future). What if the real fwrd curve is lower than Clearport data ?
The Relevant point for Spread trading is that with the independent frwd curves assessments and getting the right data, you can increase your trading by picking a considerable edge in either one or the other leg of the spread.
The Importance of choosing a partner
Learning Spread Trading is it worth it ?
Probably yes if you find a street-smart partner willing to show you.
Money can rarely be made by calling the future prices, it would take us too long to explain further why.
For the sake of simplicity, nobody can predict the future in very complex systems.
Tail-risk is what you don’t see in the prices or curves.
Tail-risk is fundamental, to me most of the money made by the smartest and most succesful traders that I’ve known is based on tail-risk.
If you need to know what is wrong and why is it wrong, better to get it quick !
Getting the right Data alone is necessary but not sufficient for being a good trader.
For us the primary goal of this activity is to avoid tail-risk, understand what is the tail-risk of others and generate trade patents from this understanding.
- In commodities, I believe that you must understand the flows from the merchandising side, the risks, and the gaming aspect of trading.
- Having the right data at the right time, represent this data and interpret this data with the underlying flows can only increase your degree of self-confidence.
- Trade pairs selection is the mother of all bomb, but given the irrational nature of markets, the outcomes for traders (survival rates) are largely determined by Risk Management.
- Not all markets are traded equal and ST, like any type of trading, is more about knowing the Don’t do list than knowing the Do List !
Your chance to break into trading: the field is wide open for candidates interested in learning how the markets work.
Having a desire to study more what’s others do wrong in the markets more than what’s right in the markets makes you the ideal candidate for spread trading.
Stay tuned, my next guest is street-smart, his firm is engaged in the very risky but highly-lucrative commodity futures game.
In January we will introduce you to the world of proprietary commodity trading.
© 2014, The Trade Shipping and Finance Wizard