Book Chapter

Intercommodity Spreads: Determining Contract Ratios

Schwager, Jack D., Etzkorn, Mark

2016

Overview

The intention of the spread trader is to implement a position that will reflect changes in the price difference between contracts rather than changes in outright price levels. To achieve such a trade, the two legs of a spread must be equally weighted. Although for most for most intramarket and intermarket spreads, equal weighting simply implies an equal number of contracts long and short, for intercommodity spreads, which can differ significantly both in contract size and price levels, the most sensible definition for equal weighting is a spread that is indifferent to equal percentage price changes in both markets. It can be demonstrated this condition will be fulfilled if the spread is initiated so the dollar values of the long and short positions are equal. An equal dollar value spread can be achieved by using a contract ratio that is inversely proportional to the contract value ratio. if intercommodity spreads are traded using an equal‐dollar‐value approach—as they should be—the price difference between the markets is no longer the relevant subject of analysis. Rather, such an approach is most closely related to the price ratio between the two markets. This fact means that for intercommodity spreads, chart analysis and the definition of historical ranges should be based on the price ratio, not the price difference.

• Publisher: John Wiley & Sons, Inc
• Subject: balanced spread / contract value ratio / equal dollar value spread / intercommodity spread
• ISBN: 9781118853757, 111885375X