StrategyTrading1

We all take a different road toward trading success. The way has unlimited branches, twists, turns  and potholes. Once in a while we stumble upon a path of gold, only to find that the road has been washed out, and we fall, head first, over a cliff, and into an abyss with little or no warning, and usually when we’re running at full speed and with a smile on our face.

Such was my experience with spreads - specifically, Treasury Bill futures spreads.

After my initial experiences with futures trading in the early 1980’s, I decided to take a deep breath and do more research before heading back into the battle. I read about futures spreads, and took out a subscription to a publication called Spread Scope. It was an unassuming booklet, rather colorless  and plain, and contained a  collection of spread graphs of all of the major futures contracts.

First, a few lines about spreads. I found out that trading “raw” futures contracts can be dangerous - very dangerous. Even if you have a system with stops in place, once in a while some bit of news hits the tape, and your  position can go into either the stratosphere or the tank. And, as I found out with Orange Juice futures, your position can go limit up or down for several days in a row. If you happen to be on the correct side of the move, you couldn’t be happier. But, if you’re on the wrong side, you can be in for a rough ride to financial oblivion.

With a spread, you are both long and short the same commodity. So, if a limit move occurs you at least have  a chance of surviving.

Now, spreads do have volatility, but they aren’t nearly as volatile as the underlying contracts, so many traders of futures, or options, have figured out that spreads can be not only safer, but more profitable, than trading the underlying instruments. And because spreads are safer and less volatile than their “raw” contracts, the margin to trade them is substantially less. Instead of $1000-3000 , margin might be as low as $150.

As I flipped through the pages of Spread Scope one thing jumped out at me. The spread lines of the financials - Treasury Bills and Treasury Bonds, looked a lot smoother than other spreads. Another light going off in head.

The way to make money trading is to find a trend and just ride it. The less volatile the trend, the better. In other words, the smoother the trendline, the more likely it is that you can make money trading it, because the pullbacks and whipsaws are minimized. I call charts with smooth lines “smoothcharts”.

I was so interested in these smooth financial spread lines, that I sent for all the back issues of Spread Scope that were available. I collected several years of issues, and each one showed the same thing - smooth upsloping spread graphs of the financials. And, the smoothest lines belonged to the Treasury Bills.

The reason for this is that bills are sold at a “discount”. Over time the value of the bill rises at a rate that can be mathematically described as a log.  If interest rates remain steady or fall, treasury bills and their underlying futures rise at a steady rate until they expire, and more bills are issued. Treasury Bill, and later Eurodollar, futures were available for trading in various strikes - the shortest being three month bills. The three month TB spreads had the least volatility and the smoothest trendlines. As an example, if the month is August, you bought the September bill and sold the December bill. You were then long a three month Treasury Bill spread. The margin cost was $150 and you made $25 for every 1 cent of price movement, which was almost always up.

My Spread Scope research indicated that trading these spreads was the closest thing to a “sure thing” that I had ever found, so I decided to start trading them.

I called my broker at Lind Waldock and  bought one spread. I made some money. I bought another. I made money. My account balance at the time was under $5,000. As the account gained value, I had more money to buy more spreads.

Let’s step back for a minute and look at the larger picture. In the late 1970’s and early 1980’s there had been a terrible period of inflation and interest rates had skyrocketed. Thanks to a recession and Paul Volcker’s tight- fisted monetary policy, rates began to fall, and this was the perfect environment for rising bill and bond prices, and, as it turns out, this was the reason why the spreads were doing nothing but going up.

My account value began to increase at a fast pace - first to $10,000, then to 20, then to $50,000. By the time it hit $83,000 I was trading about 50 spreads. Each time TB futures increased by .01 I made another $1,250.

Then, one day, the Feds made an announcement and decided to change policy, and interest rates reversed course with a vengeance.  

At the moment of their statement  rates spiked in a move that hadn’t been seen in years, and my spreads began to plunge.

I had been plotting them on my point and figure charts, and at the end of the day the charts signaled a “sell”. However, I had never seen a sell like this before and it looked like an anomaly. So, the next morning I decided to watch the market to see if the spreads would rebound. They didn’t and my 50 spreads plunged, so I sold some. Now, with all trading there is something called “commissions and slippage”. This can hurt, especially on market orders of large numbers of spreads. You have to pay a commission on each side of the spread, and there is slippage on each side. Bottom line - money goes away very fast.

After I sold off some spreads, I was forced to sell more. Then, the market rebounded, and I got a buy signal on my charts, so I stepped back in and bought more spreads. Of course, this was a “whipsaw” and the market plunged again, so I got a sell signal, and sold more spreads. This back and forth continued. Not only was the smooth uptrend of the previous several years broken, but my trading system stopped working, and my account value continued to fall.

The next few weeks didn’t go well, and to make a long and painful story very short, by the time I stopped trading ,my $83,000 had plunged to $3,000. Now, this seems hard to believe if you haven’t traded futures before. However, I can assure you that my story is being repeated over and over again all over the world as you read this.

When my account was going up daily, I was euphoric. When it all came to a crashing halt, I was just stunned. Welcome to the wonderful world of fear and greed, or is it greed and fear.

I told myself that it had been better to experience this with “only” $83,000 than millions. My losses were “tuition” paid to the school of hard knocks and experience. And, after all was closed out, I had only lost, really, about $2,000.

And what did I learn from all of this? Well, I did learn that markets go down a lot faster than they go up. I learned that bubbles do burst, and when they deflate the air goes out of them very fast. I learned that the same over-leverage that can propel you into the financial thermosphere can just as quickly smash you into the dust. Reward IS proportional to risk.

I learned that it’s extremely difficult, and likely impossible, to come up with a trading system that works in all types of markets. A trend following system will get smashed in a choppy market. And, a system that tries to pick tops and bottoms in a channeling market will get blown out in a trending market, and you never know when a market will change from trending to choppy and back again.

I found out about commission and slippage costs and gap openings. But, the real lesson learned was about myself and how I reacted to wild market swings. I found that I just couldn’t resist the temptation to buy as many spreads as my margin would allow, and how that level of greed and over-confidence would play out in real time. And, when I hear about traders who blow billions of dollars, I understand how it happened, except on a much different scale.

Eventually, Treasury Bill futures became unpopular, and Eurodollar futures took off, and many years after my spread experience, I got on board the Eurodollar express on an even larger scale, a story I will tell in another post.