Filed under: online trading methods | Tags: "John Netto", One shot one kill trading
Tim Bourquin: So talk about how you figure out which markets would be not correlating to themselves or correlating in opposite directions to know which ones to buy and sell.
John Netto: Sure. First of all, if they’re going to spread trade, there’s a couple of — you could spread through a highly correlated markets or, you know, obviously, with everything else, the more risk, the more award. You could step back and trade less correlated market. So a highly correlated spread would be, you know, The Dow Jones EURO STOXX 50 versus The DAX, okay. They both encompass European equity. They both are nominated in Euros so there’s no currency risk there. I can, you know, the two have a historical correlation that’s pretty strong north of 95%. And as a result of that, if those two spreads deviate, they may present some opportunities there and so as well to that okay. So correlation is the first key component. Second, like I talked to you about is currency. You know, having a spread in currency alleviates some of the currency risks that can come if you spread other products.
Third thing is well — is like an ebb and flow. So with spread trading there are mean reversion strategies. Meaning that if there’s a high correlation, that correlation diverges, you play a strategy that they will, you know, come back in line again so that’s more, you know, a value proposition. And also trend following strategies as well. You take a look at the crude curve, all right. You know, the energy markets, some of the agricultural markets and when you see crude trend in higher, I mean this isn’t always the case clearly but when crude was rallying like it was in late 2007 or early 2008, we had what’s called the backwardation dynamic. Meaning that, you know, the price of front month crude contract was actually priced higher than the back month crude contracts. This, you know, was a very tell-tale sign of the dynamic that was in play when crude got as high as $145 a barrel. Whereas, when crude topped out and started to head south, we went all the way back down the, you know, south of $30 a barrel. We had a huge dynamic or a steepening curve. Meaning it’s like front month crude was priced at whatever — $28 a barrel. In one month that was priced at $36 a barrel. Whereas in backwardation, front month was priced to, let’s say, $140 a barrel and back month was priced like $137. So those — that supply and demand dynamic in how those markets are priced all plays a role.
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