FCPO Spread Trading Strategy

Detailed Explanation

The FCPO Spread Trading Strategy focuses on the relative price movements between different contract months rather than outright directional price moves. This approach reduces exposure to overall market volatility while capitalizing on the mean-reverting tendency of spreads between related contracts. It's particularly effective during contract rollover periods and when there are temporary supply/demand imbalances affecting specific delivery months.

Spread trading involves simultaneously buying one contract month and selling another, with the goal of profiting from changes in the price relationship between the two contracts rather than from absolute price movements. This creates a form of relative value trading that is less dependent on overall market direction.

This strategy works particularly well for FCPO because:

• FCPO contract months typically maintain predictable price relationships based on carrying costs and seasonal factors
• Temporary disruptions in these relationships often revert to the mean
• The strategy provides reduced volatility compared to outright directional trading
• It performs well during contract rollover periods when other strategies may struggle
• It offers a way to trade FCPO during range-bound or uncertain market conditions

Entry Rules

1. Identify the spread relationship:
   • Calculate the price difference between two FCPO contract months (e.g., current month vs. next month)
   • Plot this spread on a chart and calculate its 20-day moving average and standard deviation
2. Entry criteria for spread widening:
   • Go long the near-month contract and short the far-month contract when:
   • The spread is at least 1.5 standard deviations below its 20-day moving average
   • The spread has shown signs of stabilization (2-3 days of narrowing spread)
   • Volume in both contracts is above average
3. Entry criteria for spread narrowing:
   • Go short the near-month contract and long the far-month contract when:
   • The spread is at least 1.5 standard deviations above its 20-day moving average
   • The spread has shown signs of stabilization (2-3 days of widening spread)
   • Volume in both contracts is above average

Example of a spread widening entry setup using the FCPO Spread Trading Strategy

Exit Rules

1. Profit targets:
   • Primary target: When the spread reverts to its 20-day moving average
   • Extended target: When the spread moves 1 standard deviation beyond its 20-day moving average in the opposite direction
2. Stop loss:
   • Exit if the spread moves against the position by 1 standard deviation from entry
   • Alternative: Use a maximum loss of 2% of account value
3. Time-based exit:
   • Close the position if the spread hasn't moved toward the target within 5 trading days
   • Mandatory exit 2 days before the near-month contract's last trading day

Example of exit points for a spread trade

Risk Management Parameters

• Position sizing: Risk 0.75% of trading capital per spread trade
• Maximum open positions: 2 concurrent spread positions
• Correlation check: Ensure the two contract months have historically shown strong correlation (>0.85)
• Avoid entering new spread positions during major economic announcements
• Drawdown control: Reduce position size by 50% after two consecutive losses
• Daily loss limit: Stop trading for the day if losses reach 2% of account value

Performance Metrics

Implementation Tips

• Contract Selection: The most liquid spread combinations are typically between the front month and the second month, or between the second and third months.
• Seasonal Patterns: Be aware of seasonal patterns that affect spread relationships, particularly around harvest periods and weather events.
• Spread Calculation: Consistently use the same formula for calculating spreads (e.g., near month minus far month) to avoid confusion.
• Historical Analysis: Study the historical behavior of specific spread combinations to understand their typical ranges and volatility.
• Liquidity Consideration: Ensure both contract months have sufficient liquidity before entering spread trades.
• Fundamental Awareness: Stay informed about factors that might affect one contract month differently than another, such as storage issues or export policies.

Common Mistakes to Avoid

• Ignoring Liquidity: Avoid spread combinations where one of the contracts has low liquidity, as this can lead to slippage and execution problems.
• Overleveraging: Despite the lower volatility of spread trades, avoid excessive leverage that can magnify losses during correlation breakdowns.
• Neglecting Rollover Dates: Always be aware of the last trading day for the near-month contract to avoid forced liquidation.
• Chasing Extreme Moves: Wait for signs of stabilization before entering a spread trade, rather than trying to pick the exact turning point.
• Ignoring Transaction Costs: Remember that spread trades involve two transactions (entry and exit) for each leg, so transaction costs are higher than for outright trades.

Case Study: Successful FCPO Spread Trade

Trade Setup:

• The spread between the current month (FCPO1) and the next month (FCPO2) contracts was tracked
• The 20-day moving average of the spread was 35 MYR with a standard deviation of 8 MYR
• The spread widened to 55 MYR, which was 2.5 standard deviations above the moving average
• After three days of continued widening, the spread showed signs of stabilization
• Volume in both contracts was above the 10-day average

Trade Execution:

• Short FCPO1 at 3,520 MYR and long FCPO2 at 3,465 MYR (spread of 55 MYR)
• Stop loss set at a spread of 63 MYR (1 standard deviation wider)
• Primary target at a spread of 35 MYR (20-day moving average)
• Extended target at a spread of 27 MYR (1 standard deviation below moving average)

Trade Outcome:

• The spread narrowed to the primary target of 35 MYR within 4 trading days
• FCPO1 was bought back at 3,485 MYR and FCPO2 was sold at 3,450 MYR
• Profit on FCPO1 leg: 35 points (3,520 - 3,485)
• Loss on FCPO2 leg: 15 points (3,450 - 3,465)
• Net profit: 20 points per contract, or 500 MYR per contract pair (20 points × 25 tons)
• Return on risk: 2.5:1 (20 points gain vs. 8 points risked)