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How To Trade Oil Futures – The Basics

Crude oil (CL) is one of the more active commodities to trade. It has tremendous volatility and excellent liquidity. Oil is affected by global economic and political conditions, almost to the same extent as US Treasuries. The price of crude oil affects the price of many other assets, including stocks, bonds, currencies and even other commodities. This is because crude oil remains a major source of energy for the world and is a defect currency in many ways.

Crude Oil Contract Specifications:

  • Ticker Symbol: CL
  • Exchange: NYMEX
  • Trading Hours: 9:00 AM – 2:30 PM EST.
  • Contract Size: 1,000 U.S. barrels (42,000 gallons).
  • Contract Months: all months (Jan. – Dec.)
  • Price Quote: price per barrel. Ex $65.50 per barrel
  • Tick Size: $0.01 (1¢) per barrel ($10.00 per tick).
  • Last Trading Day: 3rd business day prior to the 25th calendar day of the month preceding the delivery month.

Cude Oil Fundamentals

  • Light Sweet Crude Oil is traded on the New York Mercantile Exchange (NYMEX). “Light Sweet” is the most popular grade of crude oil that is traded.
  • Crude oil is the raw material that is refined to produce gasoline, heating oil, diesel, jet fuel and many other petrochemicals.
  • Russia, Saudi Arabia, and the United States are the world’s three largest oil producers.
  • When crude oil is refined, or processed, it takes about 3 barrels of oil to produce 1.5 barrels of unleaded gas (RB) and 1 barrel of heating oil (HO).​

Crude Oil Reports

This report is released every Wednesday at 10:30 PM EST, unless there’s a holiday, then it’s released on Thursday at 11 AM EST. The report is usually considered bullish if the actual reported inventory is significantly lower than the expected inventory level, and bearish if it is higher. We say usually because there may be other factors that could affect how the market perceives the report, such as seasonal conditions, or storage anomalies.

TIP: On the days of the report, if you are a day trader or scalper, my experience says don’t trade Crude Oil between 8:50 Am and 10:35 AM EST. The market is erratic on report days during these hours. Wait until the report has had a chance to settle and the market digests its content before trading.

Price Movements

The price of crude oil (CL) is highly correlated to the economics of gasoline (RB) and heating oil (HO). In fact, all three of these contracts are often traded together either for hedging by refiners, or speculation by professional traders in what is called the Crack Spread.

The Crude Oil market is by and large a trending market. There is a high level of volatility however, which can cause price to jump or plummet. These spikes are typically followed by a regression back to the mean direction, unless the event results in a major supply disruption. Crude often gets stuck in prolonged ranges after a big move, identifying these ranges is crucial to exploiting excellent trading opportunities.

The U.S. dollar is a major component in the price of oil. A higher dollar puts pressure on oil prices. A lower dollar helps support higher oil prices. Crude oil also tends to move closely with the stock market. A growing economy and stock market tends to support higher oil prices. However, if oil prices move to high, it can stifle the economy. At this point, oil prices tend to move opposite the stock market. This usually becomes a concern when oil moves above $100. In the past, prices in the $120-130 range bring about capitulation.

Profit Targets for Day Traders

When day trading Crude Oil futures set your profit target between 0.15 to 0.20 cents. This seems to be in line with the intraday swings for the CL contract.

A Target of 0.15 cents with a single full-sized contract translates to $150 ($10/tick or 0.01) and 0.20 cents equals $200, so that’s plenty of profit potential but it’s not going to make outsized demands on your trading strategy like if you were shooting for a lot more, like 0.40 or 0.50 cents. I’m not trying to tell you there aren’t bigger moves, in fact I’ve seen plenty of times rallies go well beyond $1.00 or more. I’m just trying to give you a target that can make profits consistently.

Day Trading Crude Oil Futures

Crude oil is one of the favorite markets of futures day traders. The market typically reacts well to pivot points and support and resistance levels. You have to make sure to use stops in this market, as it can make very swift moves at any given time. It is best to day trade within the context of a larger global macro strategy, rather than rely on pure technicals.

There is no shortage of trading opportunities in crude oil from day to day. The market is very active and it has plenty of volume. Crude oil is a 24 hour market, so be cautious of possible overnight moves that can take you by surprise. Much of the same principles that apply to stock index futures also apply to crude oil futures. If you like trading the e-mini S&P, you will probably like crude oil too.

Crack Spread Trading

In my opinion, day trading technicals is too risky, but many traders find it okay. I prefer to trade a spread, like one of the Crack spreads. My favorite is Crude (CL) vs. Heating Oil (HO) in a 1×1 spread, because of the very high correlation between the two products (r = 0.90 on a daily basis). This provides a level of risk aversion because it’s essentially a hedged trade. The primary trading methodology is mean reversion.

There are other popular Crack Spreads, such as Crude (CL) vs Gasoline (RB), and an all inclusive trade with Crude, Heating Oil and Gasoline, which is usually traded in the ratio of 3x2x1, but this is typically the type of trade a refiner would do to hedge their business

I trade Crude vs Heating Oil, and offer a course and mentorship program for this spread. If you are interested in learning to trade the Crack Spread, contact me at 508-446-0517. And look out for future posts on the Crack Spread.

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What Is The BoB Spread?

The BoB spread is a type of yield curve spread, it depicts a spread between the very longest maturity treasuries, the 30-year Bond and the 30-year Ultra Bond. So, what’s the difference, and why is this such a good trading vehicle?

Here’s the part of the yield curve that the BoB spread represents, indicated by the segment in red. It is very unusual for this segment to be pointing down, while the rest of the yield curve is pointing up.

The BoB spread represents the delivery of the longest maturity treasury products. But wait, they are both 30 year bonds, right?

Yes, it is true, they are both 30 year bonds, but the treasuries they can potentially deliver upon expiration when the contracts expire is very different. What you probably don’t realize is that when a Bond futures contract expires, you don’t get a pristine Treasury with a full 30 years left until maturity, what you do get is a possible range of previously issued 30-year bonds that could have a wide range of time left until they mature.

30-year Bonds deliver a product with between 15 and 25 years left until maturity, while 30-year Ultra Bonds deliver between 25 and 30 years left until maturity. Because the Ultra is further out there, the face value is generally priced a bit higher than the regular 30-year bond. Also it’s price is a bit more volatile.

Highly Correlated

The good news for traders is that because they represent essentially the same thing, just different groupings of the same thing, so they are highly correlated, and as such make excellent spread trading partners. The correlation between these two products generally hovers in the high 80s and low 90s on the correlation coefficient scale.

Excellent Movement Tied to Global Macro Events

The BoB spread is an excellent barometer of where the economy may be heading. It is often used as a leading indicator for the shorter maturity Treasury products. In fact, right at this moment, it appears that long bonds are predicting a flattening of the yield curve, with a rather significant divergence over the past week or so.

You can see this very clearly on the yield curve chart at the top of this post, as well as the change in the moving average in the notional chart just above.This is the Bond market saying they expect some sort of change in global events that will affect things well into the future for the worse, perhaps this is a prediction of the French election.

Bonds Lead All Markets

There’s a reason it is often said that the smartest traders on the planet are the bond traders, and that’s because they are also tuned into all the big global macro events around the world. So, if you like trading in the big picture, there’s no bigger way to trade than with Treasuries and the yield curve.

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Highly Correlated Spreads

Spread or pairs trading is a very effective way to hedge your risk exposure to the movements of the broader market. With pairs trades you can make profits through simple and relatively low-risk positions. The trade is market-neutral, which means the direction of the overall market does not affect profit or loss…it’s the change in the relationship between the pair that you are trading.

The primary goal in choosing a pair to trade is that they are highly correlated. This correlation ensures that you are trading the relationship and not the price. You make profit by waiting for the difference in price to diverge by some statistically significant amount. This change represents the divergence in the relationship. At some point this relationship has a very high probability of regressing back to the original price difference. The higher the correlation, the higher the probability that the relationship will regress back.

So, we use statistical tools to measure correlation with a measure called the correlation coefficient, which is on a scale from -1 to +1. A +1 indicates perfect correlation, while a -1 indicates perfect inverse relationship. There are virtually no pairs with perfect correction, but pairs with coefficients above 0.70 are considered to be candidates for pairs trading. Mathematical proofs have shown such pairs have a 75% probability of regressing after a divergence.

This is a very strong edge that traders can use to their advantage. And the reason why pairs trading is so popular with hedge funds, investment banks and professional traders. Very few retail traders use the strategy because there are few good intuitive to use tools available. FYI, if you take my course you will be provided such tools.

Finding Great pairs Can Be Challenging

Unless of course if someone does it for you. And that’s what I have done for you here. I have ferreted out the futures contracts that have the highest correlations. I personally trade most of these pairs using a proprietary methodology and set of rules, employing a strategy called statistical arbitrage.

 

The “r” value is the correlation coefficient of the pairs shown. The charts plot the difference in the notional value of the pairs. That’s what we analyze using statistical tools to determine when to act on the trade. All the pairs use a ratio of 1 to 1. Meaning the smallest position size would be 1 contract long and 1 contract short. My favorite trades happen to also be the most highly correlated. Two are Treasury futures called the NoB and FYT, and the other is an Energy futures pair called the Oil-Heat which is a type of Crack Spread.

There’s a fantastic tool available on the CME Group website that helps identify the most highly correlated pairs called the Cross Correlation Calculator. The screen shot below shows the tool, and I have blocked off the most correlated pairs. There’s very few that every achieve a correlation Coefficient higher than 0.60, which is the standard I used for blocking them off. I wouldn’t trade the pair unless it had a value greater than 0.75.

In future articles I’ll go over each of these pairs and talk about specific strategies that can be employed on top of the basic statistical arbitrage strategy that will further increase your probability of profit. If you would like to learn how to execute those strategies now, then sign-up for my course, it’s a fantastic value, and includes one-on-one lessons and mentoring.

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Yield Curve Is Flattening But Which Spread Should I Trade?

There are many variations of the yield curve to trade, and it can be confusing which is the right one for your needs. So you may be wondering, which should I trade?

The answer is relatively simple, if you understand your personal capacity and tolerance for risk, and whether you are a long-term or short-term trader. Another consideration is a bit more practical, as some of the spreads may cost significantly more on a risk-return basis than others. So, this is your homework before you put your money to work.

The charts below show a bunch of different yield curve spreads involving the 2-year note as the front leg. Going clockwise, starting from the upper left chart, it includes the Ultra 30-year bond (3:1 ratio), the 5-year note (1:1 ratio), the 10-year note (2:1 ratio), and the 30-year bond (3:1 ratio). The chart also shows the range in price of the spread, with a high in March and a low in April of 2017.

So, from a risk perspective it’s clear that the spreads with bigger dollar ranges present more risk. These are the TUL and TUB spreads, which pair up the 2-year with the 30-year bond and ultra bond respectively. The TUL and TUB are also a bit more expensive to put on as well because there are more contracts necessary to execute the proper ratio trade, but the expense to return is much lower than the other two.

A large range would indicate more risk, depending upon the size of your account. A very large account would have greater flexibility, while a smaller account may be restrictive to certain spreads. Small accounts would find the TUT and TUF spreads more palatable.

The TUT and TUF spreads are also slower moving than the TUL and TUB, as they react more slowly to global macro events and changes in monetary policy. So, these spreads may be better for someone that is not as active a trader as others, or prefers position trading over swing trading styles.

The downward arrows indicate a flattening yield curve, so the appropriate strategy would be to short the spread. This means short the front leg, and go long the back leg. It’s a flattener trade when we have a downward sloping moving average. This simply implies that the front leg of the trade (2-year note) is weaker than the back leg, evaluated since the beginning of 2017. One can assume that longer term yields are falling faster than shorter term yields, and are likely to continue that way, so long as the trend is down.

Conclusion

So to sum it up, if you have a larger account and are a more active trader, then the TUL or TUB spreads may suit you. If you have a smaller account, or you prefer a trend trading style, then the TUT or TUF spread may be best for you.

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What Is The TUT Spread?

In a previous post on Yield Curve Trading I list all the popular yield curve spreads that institutional and professional traders watch. The TUT spread is the 2-year over the 10-year Treasury futures spread. It’s a pairs trade that’s the difference between the notional values of the two contracts (cash value of the contracts).

This spread is considered significant with regard to the shape of the yield curve, giving traders a clue as to where yields may be heading. The yield curve plots the yields of all the different maturity treasury products, from the 3-month to the 30-year. Economists use the shape of the yield curve to predict future economic conditions.

Is The Yield Curve Steepening or Flattening?

The basic strategy for yield curve trading is to determine whether the curve may steepen or flatten. This will provide you with the primary direction you want to trade. You go long the spread if you believe the curve will steepen, and short the spread if you believe it will flatten.

A steepening curve is one where long term yields are increasing faster than short term yields. And a flattening curve is one where short term yields are rising faster than long term yields. Keep in mind that the price of Treasury futures is inverse to yield.

How to Trade Steepeners and Flatteners

When you put on a steepener, you are going long the front leg of the spread (2-year) and short the back leg of the trade (10-year). Remember price is inverse yield, so you would be expecting the yield of the Front leg (2-year) to underperform the yield of the Back leg (10-year). So a steepener is used when you think longer term yields will be rising faster than shorter term yields.

When you put on a Flattener, you are going short the Front leg (2-year), and long the Back leg (10-year). You’re expecting shorter term yields to rise faster than longer term yields.

With a longer term notional chart of the TUT spread you can visualize the steepening and flattening of the yield curve. When trending up, the yield curve is steepening, and when trending down, it’s flattening..

 

Trading with the Proper DV01 Ratio

When trading the TUT, as when trading any of the yield curve trades using futures, you need to be aware of what the proper weighting is for the Front and Back legs. This is because you need to remove the price risk associated with the futures contract due to the non-linear relationship between price and yield. To do this we need to find out how much a contract changes in price for each basis point in yield. This is called the Dollar Value of One Basis Point or DV01. Once we have the DV01 of each contract we can divide one by the other to get the ratio. This will be the weighting, or ratio between the front and back legs.

The calculation for DV01 is a bit involved. You can use a spread sheet and devise your own calculator, or you can use one that the CME Group provides here.

The goal of the ratio is to create relatively equal sided trades in terms of yield. It’s similar to options trading where you attempt to make your trade delta neutral. In this case we can see that the DV01 for the 2-year is approximately 1/2 that of the 10-year DV01 ($37.04 and $78.90 respectively). So it will take two 2-year contracts for each 10-year contract to create a Dollar Value neutral trade.

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Dollar Value Hedging Treasury Futures

When we speak of hedging, what we’re really talking about is a pairs trade, where we go long one asset and short another. We hedge to take advantage of several key aspects of Treasury futures. The most important is the edge we get by eliminating the directional aspect of price (minimizes risk) and focusing instead on yield direction. This is important, because the fluctuations of price are very difficult to trade, but the direction of yield is simple due to the slow moving Federal Reserve monetary policies.

The problem we face as traders is how to isolate yield from price of the individual treasury futures contracts. The way we do that is by translating the dollar value of the treasury instrument to the yield. This is called the DV01, or dollar Value of One Basis Point (of yield). So, by calculating the DV01 of each side of the hedge, we can then divide one by the other to get a ratio, and this ratio will represent the relative size of each side of the trade, and we can round that number to give us the ratio of contracts on either side of the trade.

This process requires a formula, which is nicely represented as an Excel formula, making it super simple to calculate the DV01, and thus the ratio we are looking for. This ratio changes over time depending on the price and yield on the treasury instruments. So periodically we have to check this ratio to update the position sizes we take with trades, to make sure we are trading changes in yield and not price.

Here’s a diagram that shows the non-linear inverse relationship between price of a bond and yield. As the price of a bond goes down, the yield goes up in an accelerated fashion, when the price of a bond goes up, the yield goes down in a decelerated way. This shape creates a situation called convexity, which refers to the shape of the curve. The tangent line is an approximation of the price at maturity, called duration.

Calculating the DV01

There are two well known ways to calculate the DV01 of a treasury instrument (bill, note or bond). The first is to measure price sensitivity over a small incremental change in the security’s yield. The second way is using the treasury security’s modified duration. The duration method can be complicated, so we will focus on the yield sensitivity method, which is relatively simple.

The yield sensitivity method is accomplished by finding the difference between two absolute prices of the same treasury instrument over one basis point (bp) change in yield. Here’s the formula:

 

Using Excel’s PV function we can create a relatively simple tool to calculate DV01 of both sides of the pairs trade. All you have to do is input the current yield of the respective Treasury instruments. Below is a sheet that calculates the hedge ratio for the Notes over Bonds (NoB) trade. If you are interested in obtaining this Excel sheet, contact me and I will share it with you.

 

The hedge ratio rounds up, so the proper hedge of the 10-year Note vs the 30-year Bond is 2 to 1. So, using this ratio in your trade analysis removes the risk of trading non-linear price movements and instead trading only differences in yield. If you are interested in learning more about trading the yield curve I’m offering a course and mentoring program under the Learn tab

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Yield Curve Trading

Yield Curve trading using futures has been the bread and butter of large institutions and professional traders for decades. This type of spread trading offers excellent returns and hedging opportunities in one of the most liquid markets in the world, US Treasuries.

In our opinion, broader adoption to this type of trading into the retail market has been hampered due to the lack of intuitive, easy to use tools. Spreads by their very nature are difficult to understand because of the moving parts. But the strategies most traders use are quite simple and super-reliable.

We offer custom trading tools that make it simple to execute spread trades with futures using the TradeStation platform. The tools are intuitive and easy to use, allowing the trader to take full advantage of the strategies employed by professionals. Check out our course on Trading the Yield Curve, to get these tools, along with one-on-one training and mentoring.

One of the benefits of trading yield curve spreads besides the incredible liquidity and reliable strategies, is the margin offsets, or discounts, making the cost of executing a yield curve spread trade very small relative to the capital you put to work. This allows the trader flexibility to be risk savvy, yet carry sufficient leverage to achieve impressive returns on capital.

The Yield Curve as a Leading Indicator

Since the late 1980’s there has been significant research done across the industry and within the Federal Reserve that documents the empirical regularity that the slope of the yield curve reliably predicts future real economic activity. For example, every recession has been preceded by a flattening of the yield curve.

The slope of the yield curve is primarily influenced by the central banks’ monetary policy and inflation expectations. The Fed will raise rates to cool down heated economies, and lower rates to provide stimulus. So, steep yield curves reflect periods of stimulus, and flat curves reflect periods of tight monetary policy.

A practical way to model this is with yield curve spreads, like the difference between the 10-year bond and 3-month bill treasury rates, to calculate the probability of a recession in the US 12 months in advance. The spread makes a low approximately 12 months prior to a recession. This chart goes all the way back to 1959.

We can also model this using futures spreads like the TUT, or 2-year vs 10-year notes. Here’s a chart going back to the beginning of 2006, notice how well it correlates to the same period in the 10-year vs 3-month chart above, predicting the recession in 2009.

Yield Curve Strategies

The primary strategies employed by most professionals to determine the direction of the yield curve trade, look at whether the curve is steepening or flattening. A steep yield curve is the normal, healthy orientation of the curve, it occurs most often. The curve flattens usually as a consequence of the Federal Reserve policies, including rate hikes and liquidation of the balance sheet. These are policies that are employed in an attempt to cool down an exuberant market.

When we say go long the spread, like the TUT spread, we mean go long the shorter maturity leg (Front Leg) and short the longer maturity leg (Back Leg). The Front Leg is ALWAYS named first in the spread, so the TUT is the 2-year vs the 10-year note spread. So when we go long the TUT, we are long the 2-year and short the 10-year. We only go long when the yield curve is in a steepening mode, and we only take shorts when the yield curve is in a flattening mode.

Execution Risks

The risk in the yield curve strategy is measured using the DV01 (dollar value of a basis point), so you would calculate the DV01 of both the Front and Back Legs of the spread and find the ratio, this will determine the approximate ratio of contracts to use in the trade.

The CME Group does this calculation for you, and displays these ratios as a reference to traders on their website. The proper risk adjusted ratio to use for the TUT spread is 2:1, or two 2-year contracts for every one 10-year contract.

There are many other related yield curve trades using the various maturities, and each has an associated risk measure and recommended ratio of Front to Back Leg position size. By using this ratio, you more or less eliminate movement of the spread due to price, and isolate instead the movement of yield. Here are the popular yield curve trades using treasury futures and TradeStation symbols and the calculated DV01 ratio as of April 2017.

Spread Name Front Leg Back Leg CME Ratio
TUF 2YR (TU) 5YR (FV) 1:1
TUT 2YR (TU) 10YR (TY) 2:1
TUB 2YR (TU) 30YR Bond (US) 3:1
TUL 2YR (TU) 30YR Ultra Bond (UB) 3:1
FYT 5YR (FV) 10YR (TY) 3:2
FOB 5YR (FV) 30YR Bond (US) 3:1
FOL 5YR (FV) 30YR Ultra Bond (UB) 3:1
NOB 10YR (TY) 30YR Bond (US) 2:1
NOL 10YR (TY) 10YR Ultra Bond (TEN) 3:1
BOB 30YR Bond (US) 30YR Ultra Bond (UB) 3:1

 

Is The Yield Curve Flattening or Steepening

So, the strategy is simple, you go long the spread when the yield curve is steepening, and short when it’s flattening. But how can you tell if the yield curve is steepening or flattening? A steepening curve is the predominant situation, in other words, long term rates are usually higher than shorter term rates, probably 70% of the time. But occasionally, when the Fed is attempting to reel in a market because of over inflation concerns, they might increase short term rates, causing the yield curve to flatten.

The big question in terms of flattening or steepening is, what’s the time frame you are trading in? If you are trading very short term, by that I mean similar to a swing trader, where trades are open for a couple days to a couple weeks, then your idea of steepening or flattening may be very different from someone trading long term, like a position trader.

I trade short term, so I want a measure that effectively captures the general direction of the yield curve, so that the choice of whether to go long or short, is for the most part coincident with the direction of the yield curve. This will give me the best probability of a successful trade, kind of like trading with the trend, the trend is you friend. So, I use the TUT or TUB spread weekly chart, and add a 2 line moving average, where the fast line is set to 25 and the slow line set to 30. I then look for cross overs to determine when the yield curve is changing direction.

The TUB spread covers almost the entire yield curve, where the TUT spread covers only a portion of the shorter term yields. You may have to experiment with this to find the best indicator. If you are a NOB trader, then maybe you are only interested in the upper end of the curve, so the FOB might be a better choice.

If the moving average slope is not very big, then you might want to hold on to the current strategy of steepening or flattening. Also, depending upon your entry strategy, it might make sense to favor either steepening or flattening. You’ll have to do the back testing to determine your own rules. I have developed a large set of conditions based on about a decade of trading yield curve spreads, along with detailed, multi-time frame analysis.

Here’s an example of using a notional chart of the FOB with 2 moving averages to determine the strategy to employ.

There are many ways to determine when to switch strategies. There are also effective sub strategies that layer on top of the steepening/flattening strategy that are very effective as well. One example might be trading only US economic reports and fading the move, or trading with the direction of the move.

If you would like to learn how to trade the yield curve, and obtain our tools that make trading it simple and intuitive, then click here to sign up for our one-on-one training and mentoring program.

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Statistical Arbitrage Basic Strategy

Statistical Arbitrage is a pairs or spread trading strategy, predominately used by hedge funds, investment banks, and professional traders. The strategy involves tracking the difference in notional value between two highly correlated instruments, like Silver and Gold futures, or the NoB spread, which is a trade between the 10 year and 30 year treasury futures contracts. The notional value is the actual cash value of a futures contract. Statistical Arbitrageurs trade the notional difference of the pair. Here is how you calculate the notional value of a futures contract, and then the notional difference between a trading pair:

Notional Value = Current Price x Big Point Value

Notional Difference A & B = Notional A - Notional B

There are three key features in this strategy. The first is that when the difference in value between a trading pair changes in a statistically significant manner, perhaps due to some market shock, there is a high probability that that change will regress back to an average or statistical mean value. There are mathematical proofs that show the probability of regressing back to the mean is 75%. Second, futures have tremendous leverage, presenting an opportunity for high return on capital. And third, most futures brokers provide a substantial discount on the total margin of a pair due to perceived reduced risk, this means pairs trades use much smaller amounts of trading capital, so more flexible risk management can be employed.[/vc_column_text]

This is a classical regression to the mean strategy, where the difference between prices is tracked, rather than just a single price. The pairs must be highly correlated assets. So, if ABC is positively correlated with CBA, and suddenly ABC is up 20 points, while CBA is down 20 points, we can assume this price dislocation is an unusual and a temporary condition, that will eventually revert back to a mean. Profit is derived from taking a position during that regression by going long the under performing asset, and short the over performing one. As they regress, profit is realized.

When selecting pairs to trade, it can be very important to draw on fundamentals, as well as statistics, to help identify relationships between two instruments. Start by pairing one instrument in a particular sector or industry with an equal dollar value and correlated instrument, typically in the same sector or industry. Look for instruments that are not only highly correlated, but also trade with good liquidity, can be easily shorted, and with minimal slippage. Example pairs might include futures contracts for Gold and Silver, Crude Oil and Gasoline, Treasury Notes and Bonds.

When selecting pairs to trade, it can be very important to draw on fundamentals, as well as statistics, to help identify relationships between two instruments. Start by pairing one instrument in a particular sector or industry with an equal dollar value and correlated instrument, typically in the same sector or industry. Look for instruments that are not only highly correlated, but also trade with good liquidity, can be easily shorted, and with minimal slippage. Example pairs might include futures contracts for Gold and Silver, Crude Oil and Gasoline, Treasury Notes and Bonds.

Determining how well a pair of assets are correlated is important to determining the viability of pair.  Remember, pairs with a high degree of historical correlation have strong regressive tendencies (75% or higher). This presents an incredible edge to traders.

A correlation coefficient is a statistical method that measures how well the price of a pair of assets moves relative to each other tick by tick. The more they move together, the higher the correlation coefficient. Values of the correlation coefficient range from -1 to +1; with a value of +1 representing a perfect positive correlation (two instruments move in the same direction every tick), a value of 0 representing no correlation, and a value of -1 meaning perfect negative correlation (When two instruments move in perfect inverse to one another).

Correlations of 0.75 or above are often used as a benchmark for Statistical Arbitrage traders. Correlation less than 0.5 is generally looked upon as a weak correlation. Factors that can weaken correlation between a pair over time include supply and demand factors, politics, interest rates, economic growth, environmental factors, etc.

To tell whether a divergence is worth placing a trade, we need to measure the move using a statistical tool. The Z-Score is often used for this, it is a measure of a price movement relative to its mean or average price. Specifically, the Z-Score is calculated by taking the the difference between the current price and the average price, and then dividing that by the standard deviation of the current price over a specific period of time. We calculate the Z-Score this way:

Z-Score = (price - Avg( price, length)) / StdDev(price, length)

A common trading strategy is to watch over bought and over sold conditions on the Z-Score when it exceeds plus or minus 1.5 to 2 standard deviations. For example; one would short the pair if the Z-Score moved above +2 standard deviations, and go long should it fall below -2 standard deviations.

Standard deviation is a statistical concept that shows how a specific set of prices are spread around an average value. Statistically, in a normal bell curve distribution of prices; 68% of prices should fall within +/- one standard deviation of the mean, 95% of prices should fall within +/- two standard deviations of the mean, and 99.75% of prices should fall within +/- three standard deviations of the mean.

Through back testing and optimization strategies, trading opportunities can be found when the notional value diverges “X” number of standard deviations from the mean. You may further find that adding filters or price sizing strategies will further improve the probability of a successful trade.

Technical analysis, fundamental analysis, or a combination of the two can be used to find trading opportunities. Fundamental factors could include major economic events, long-term trends, monetary policy, growing seasons, etc. Technical analysis might involve one or more of the following; statistical measures, analyzing chart patterns, moving averages, stochastic, RSI’s, commercial indicators, etc.

Pairs trading with statistical arbitrage is a great market-neutral strategy for high probability returns with reduced risk, but it’s necessary to have access to quality tools to model your opinions and execute the trades accurately and consistently. Also, finding a rock solid premise for trading a pair is important. In fact, the best pairs trades are ones that adhere to a fundamental condition of the pairs, or the market they are in. These conditions might determine exclusive trade direction, execution times, seasonality, or any number of domain-specific reasons that can make trading that pair extraordinary.

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Why Trade Futures Over Stocks – 24 Hour Access

When the stock market is closed, and you have a position in a stock, your hands are tied. If an opportunity arises outside of market hours, you can’t take advantage of it, and worse, if you have to exit a position, you can’t until the market opens the next day.

But in the world of futures, you are free to make a nearly 24 hours a day, six days a week*.

Political events, surprise product announcements and natural disasters don’t wait for the stock market to open. And the reality is, we live in a global economy, many other markets affect the US market…and they all trade outside US market hours.

With a 24 hour market, you can react as the event unfolds. In the US market, the vast majority of tradable events happen between 7AM and 9AM before the markets open, and all you can do is wait, hope and pray that you’ll get a chance to seize the opportunity, or get out with minimal losses.

Okay, but does that mean that you have to stay glued to your screen?

Not at all…it means you have more options to take advantage of.

Let’s say you’re long the S&P 500 with an e-mini S&P contract, and you’re concerned that China’s PMI manufacturing report is going to be negative and drive your position lower.

Instead of waiting for the report, you could place a stop order several hours before the report is released. It’ll be working for you, while you’re enjoying your evening.

*Futures Market Hours: Open Sunday through Thursday at 6PM EST, and close Monday through Friday at 5PM EST. So each weekday, between the hours of 5PM and 6PM, futures markets are closed, and closed all day Saturday.

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Why Trade Futures Over Stocks – Restrictions

Have you ever been locked out of trading because of a trading violation? Maybe your broker claimed you were a patterned day trader?

Or have you missed an opportunity due to short selling restrictions? Perhaps shares weren’t available to short? This happens a lot with small priced stocks, but can even happen with big stocks like Tesla or Apple.

Let’s look at minimum account size.

You don’t want to be tagged as a patterned day trader. A pattern day trader is someone who executes 4 or more round trip trades in stocks or ETFs within a week.

For example, you bought AAPL in the morning and then sold it a few hours later, and then the next day you shorted SPY and bought it back that same day. If you do that 4 times in the span of a week, you will be tagged a patterned day trader and your broker will shut you down and not allow you to take any new positions for 90 days…and there’s nothing you can do about it.

There is a way around this…you need to have a minimum of $25,000 in your brokerage account. Then the pattern day trader rules are lifted.

A futures trader isn’t required to meet this minimum account size. In fact, as long as you maintain the minimum margin for your positions, you can trade as frequently as you like at a size suitable to your trading needs.

Margin Restrictions

As an equity trader, you can only trade up to 4X your maintenance margin on an intra-day basis. So, if you have $30,000 buying power in your account, you can only trade up to a value of $120,000.

Exceed this amount, and margin calls may further limit your buying power and ability to trade.

In futures that same margin may allow you to trade a much larger notional value. For example, if you wanted to buy e-mini S&P 500 futures, you’d post initial margin for each contract, currently $4,750.

So, with $30,000 you could buy 6 contracts, which would allow you to control over $650K of notional value at the current index prices (12/9/2016). And you’d still have some buying power left.

That’s quite a difference in the amount you could control; $120k for equities, and $650k for futures. But let’s make something clear, nobody is saying go out there and maximize your available buying power, but it becomes clear that you can do a lot more with less by trading futures over stocks.

Shorting is a Huge Differentiator

Probably the biggest issue with equity traders these days is shorting a stock, that’s because there must be shares available to trade, and there are many reasons why shares may not be available to trade.

I had to shut down a robotic trading system that traded the wildly popular company Telsa, because there were many instances that the system couldn’t short the stock, because the broker didn’t have shares to short.

In comparison, a futures trader doesn’t have these problems. You can short any futures contract as easily as you can go long. In some cases, the government may even establish an uptick rule, preventing you from shorting a stock all together. This would never happen with futures.

And finally, when a trader shorts a stock, they need an uptick before you can short, which means if the market is falling sharply, a stock trader may never get a chance to enter a short position.

So, why miss out on another opportunity because of restrictions. The clear winner here is futures.

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