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Saturday, May 10, 2008

The Spread Trade Scam

I liked this post on Bill Rempel about "spread trades", although he sort of is missing the point. Bill Rempel says "I don't understand why spread trades are so popular."

For example, a spread trade is buying April oil futures while short selling an equal amount of March oil futures. If the March price of oil goes up, the April price should go up by an equal amount. You are owning oil for about a month. As with most long positions, you are the beneficiary of inflation and receiving a massive government subsidy.

With spread trades, *HUGE* leverage ratios are allowed. Your theoretical profit is only slight, but it is massively amplified by leverage. Under normal circumstances, you will make a decent profit. However, as with most leveraged positions, there is the chance of the occasional huge loss. Under normal market conditions, the April price of oil will be greater than the March price of oil, because there's one more month of money supply inflation. If the oil market starts suffering from severe backwardation, you can get screwed over. Backwardation is when the March price of oil is HIGHER than the April price of oil. Backwardation is due to temporary supply shortages. If you need to heat your home in March, an April futures contract is useless.

The reason spread trades are popular is that their payoff profile is as follows. You earn decent 20%-30% returns 90%+ of the time. You go bankrupt the rest of the time. As a professional trader gambling with other people's money, this is a GREAT risk/reward profile. Most of the time, you'll look like a genius and get a fat bonus. The rest of the time, you switch jobs and try again with someone else's money! An experienced trader can ALMOST ALWAYS find someone else to bankroll him, even after going broke!

3 comments:

Bill aka NO DooDahs! said...

Thanks for the link, but you actually mentioned this post of mine in an earlier post of yours.

Also, compare your final paragraph to comment #5, by me, posted 2/21/08; I clearly elucidate the same concept.

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This Blog Has Moved!

My blog has moved. Check out my new blog at realfreemarket.org.