Mar

29

One queries whether Passover, Yom Kipper, or Rasha Shauna is bearish for stocks and will say a prayer of atonement and share a torte if it turns out not so.

Anatoly Veltman writes: 

You mean Sell Rosha Shana Buy Yomkippur did out-perform Buy&Hold?

Ralph Vince queries: 

But what about Passover? What about the full moon and a shorting a (very) quiet market?

Jeff Watson writes: 

Back in the pit days, during a quiet market, locals would start selling the market down to where it would trade and order flow would start coming in.

Anatoly Veltman writes: 

Can this be a way of creating "real world" demand?

Jeff Watson adds: 

Sure, the grain companies use this same concept in the reverse to bid up the front month to get farmers to kick out some of their stored grain into the market. Right now look at may corn/wheat spread. It is treacherous and the big grain companies are slugging it out with that spread. I'm avoiding it like the plague, just like I avoided that gold/platinum inversion 1.5 years ago that went out to $150. Too rich for my blood. Very rarely does corn trade premium to wheat. Vic even asked me about doing the trade when corn was 2 cents premium to wheat(where wheat usually commands a 50% premium to corn). I told him I wouldn't touch that trade with a 10 foot pole. In my case, fundamentals and gut instinct kept me from stepping on that land mine. It's been fighting for a week, and I just prefer to be long a little May wheat and have some other months and exchanges spread. I hate risk, and also hate gambling unless I'm the house.

Anatoly Veltman writes: 

The gold-platinum, of course, was entirely different as no Gold is ever consumed. It went out to at least $225 (we should ask Rocky if he knows the high tick, and how long the price was available). To my recollection, the spread double-topped in unusually brisk manner, i.e. the record prints didn't last more than overnight.

Richard Owen adds: 

What is it about spread trades that make them so treacherous? Gold/plat, corn/wheat, the Volkswagen stub, etc.

Is it because the mis-pricing is so "obvious" that people get greedy? Because it's a matched trade, they allow too much for a positive hedging effect? And because they want to trade the spread, they focus too much on maintaining the relative basis, rather than using risk-management appropriate to a gapping short, even if it screws up the net position?

Rocky Humbert writes: 

IMHO the reason the spread trades are dangerous can be attributed to several phenomena:

1) Price Anchoring and false assumption bias. People believe that just because the spread between X and Y has been bounded previously means that this is a law. In the case of stocks, in the fullness of time, it's a good bet that every stock must eventually either merge, get taken over, divest or go backrupt. Otherwise, one stock would take over the world. This means that if you are long GM and short Ford (because it always traded within X bucks), you will eventually blowup. And because GM/F is a mean reversion trade, it has the typical person adding as it goes against you. Can you trade around it and get out at a profit? Sure. But that is intellectually dishonest versus the original motivation. I suspect trading around the position is, in reality, what most profitable spread traders do. They don't put it on, add to it and wait for total reversion. In the case of commodities, there are short-term supply and delivery issues, so even if you are conceptually right, if the convergence doesn't occur before the contract expires, you will incur a permanent loss since the mis pricing doesn't exist in the next contract. That's the case with C / Wheat right now. Corn is at a premium to Wheat in May. But at a discount in all of the other months. So you need to get the price and the timing right. Or you will lose money.

2) Difference versus percentage. I find that people look at the spread as X minus Y. They often ignore X / Y. As prices rise and decline sharply, the ratio becomes more important. But it's not how most people's minds work. For example, a 2 cent mispricing when corn is at 250 is quite different from a 2 cent mispricing when corn is at 736. Oops make that 695 (limit down)

3) False Volatility Assumptions. Assume the price of X0 and the price of Y™ and you are trading X versus Y. And assume that the spread moves up and down $1. People mistakenly think in terms of $1 on 100 … and that's not a big move. In reality, you are trading the spread of $1 and so when it moves to $2 , that's a 100% change — no different from Apple going from $444 to $888 . Don't laugh. I can't tell you how many people fall into this intellectual trap.

4) Butterfly traders. Before interest rates were pegged, I used to chuckle at the 2/5/10 butterfly traders in the bond market — who would do the trade in MASSIVE size. And they'd talk about how the 2 was cheap to the 5. Or the 5 was cheap to the 10. Deconstructing the butterfly trade revealed that (almost all of the time) the P&L of this popular duration neutral curve trade moved with the direction of the 5 year. So it really was a bet on the 5 year rising and falling. And everything was dwarfed by that.

When I was worked with Kovner, he always hated spreads. He would say that it's hard enough to get one trade right. Why add to the aggravation and try to get two or three trades right?


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