From the November 01, 2008 issue of Futures Magazine • Subscribe!

Navigating markets in the age of index funds

CALENDAR SPREAD TRADING

Spread trading in the index fund era is not for the faint of heart but can be profitable. A bull spread involves buying the front month and selling a deferred month and typically would be profitable in a bull commodity market as the front month would rally more significantly than deferred months. This began to change several years ago as the amount of money in index funds grew. Because the funds had huge positions in the front month and they would have to sell and roll out into a future delivery month, the bull spread failed despite a bull market.

After discovering this tendency, traders began to profit from buying the second month and selling the front month (a bear spread) just prior to the roll period for the index funds. Bear spreads just prior to the index roll period rarely work anymore and often result in large losses. Losses occur because too many traders are involved in this trade causing the market to do the opposite. Floor traders estimate that the amount of money in the market seeking to exploit the “Goldman roll” is near or greater the size of the index funds themselves.

During an index fund driven price spike, spreads can rally significantly. This is because the index funds are typically long the front month which rallies faster during an up move. However, these price spikes rarely indicate a shortage of supply in that commodity and therefore when the momentum subsides, spreads will steadily move back to a normal carrying charge market, which is typical in markets without supply problems. Therefore, use these spikes in the spreads as a selling opportunity: sell the nearby month and buy the deferred month. However, as stated above, try to exit the position before the index funds roll their positions. In essence you are exploiting those attempting to exploit the index roll because that trade is too crowded.

For those who invest in CTAs or other traders, it is important to determine if the growth of index funds may be jeopardizing their future profits. The warning signs that you should carefully consider when selecting or maintaining your investment in a CTA are as follows:

1. Does the CTA derive a reasonable amount of profits from trading commodities?

2. Was their systematic model developed prior to 2005?

3. Has their model been adjusted to reflect how index funds have changed the market?

If the answers to these questions are (1) yes, (2) yes and (3) no then you should carefully consider whether this CTA will remain profitable in the future.

CONCLUSION

The index funds are here to stay and understanding how they affect the futures markets is crucial to your ability to profit over the coming years. For those who jump on the bandwagon of booming commodity prices without understanding the real causes, the results can be disastrous. After over three years of poor performance from 2004 to late 2007, traders finally became significantly long commodities. However, after a lucrative six month run of profits, traders are again suffering as weakening global economies are reversing the long-term price trend of many major commodities. Understanding how index funds affect the markets is the key to staying one step ahead of changing market conditions instead of reacting after it’s too late.

Emil van Essen is the President of VanKar Trading Corporation. His CTA Commodity Spread Trading program attempts to exploit the activity of index funds. He can be reached at 800-258-4403.

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