Inter-Market Spread TradingInter-market spread trading consists of long position on one exchange and short position on another exchange in the same commodity or closely related one. The logic that works in the inter-market consists of long position on one exchange and short position on another exchange in the same commodity or closely related one. The logic that works in the inter-market spread trading is that the purchase and sale of instruments in two different exchanges exploits the correlation among them in an efficient manner. An example of this form of trading is a long position in September wheat on the Chicago Board of Trade and a short position in September wheat on the Kansas City Board of Trade. Inter-market spreads are considered very difficult to execute since they require transactions on different exchanges.The Downside to Inter-Market Spread TradingAlthough inter-market spread trading strategies attempt to generate returns by exploiting the correlation that exist between the two related futures contracts, it is unlikely that the price changes in both the futures markets will move in perfect lockstep. Thus the trader is exposed to the uncertainty arising from unanticipated relative market movements between the two legs of the spread.The adjacent graph shows the inter-market spread pricing and the relative market movements (FTSE 100 and Mid 250) over the period March 1994 to September 1996. Over the entire period there was a relative market movement of 9.2%, which reflected a rise in the value of the FTSE 100 and Mid 250 contracts of 23.6% and 14.4%. Furthermore, the correlation coefficient between the daily percentage returns on the two contracts is 0.746. Taken together these results show that while the economic relationship underpinning the returns on the two contracts is generally reasonably strong, it is far from perfect, and that on a daily basis there is the potential for considerable variation between the returns on the two legs of the inter-market spread. The figure shows the RMM series rising in the early part, declining in the middle part, and rising significantly at the end of the sample. Therefore, it is reasonable to argue that large relative market movements which are unanticipated, constitute an important source of spread trading risk which is likely to have an important bearing on the profitability of the inter-market spread strategy. Day-Trading-Strategy .com, P.O. Box 89029, Houston Texas, 77289 info@Day-Trading-Strategy.com |