The long the strongest, short the weakest concept not only applies to outright positions, but also can be an effective guide for spread trading. Indeed, spread trading is a relatively economical and safe way to start using this concept.
Spread trading involves going long one market and shorting a related market. That way, if an unexpected event occurs that causes both the related markets to move in one direction, your losses in one position will be dulled by gains in the other.
For this example, we’ll look at two Nymex contracts: natural gas and heating oil. Both markets are widely used to heat homes and tend to move in similar fashion. The natural gas contract trades in units of 10,000 million British thermal units (mmBtu). The heating oil contract covers 42,000 U.S. gallons.
After the initial break in September, heating oil had dropped more on a percentage basis than natural gas. Heating oil slipped from roughly $3.20 per gallon to $2.90, or 9.3%. Natural gas had fallen as well, but by only 2.9%, from about $8.50 to $8.25.
By September, the energy complex looked weak and many traders were looking for ways to take advantage of the fall (see “Fast break”). However, the prospects of a recovery, particularly ahead of the heating season, would make any prudent trader wary. This is when a spread trade makes a lot of sense, hedging against a possible price rise.
Using the logic from the main article, we short the weakest (heating oil) and long the strongest, relatively speaking (natural gas).
After two months, the short heating oil trade had made about $50,400 ($2.90 - $1.70 x 42,000). The long natural gas trade had lost about $16,500 ($6.60 - $8.25 x 10,000). The net gain on the spread would have been about $33,900.
While gains obviously were pared by the loss on the long trade, some of that is earned back on a percentage basis. Heating oil initial margins are $11,475 per contract, while natural gas is $9,788 (See www.nymex.com for current margin).
However, exchanges recognize the correlation of certain markets through spread margins, reductions in margins for offsetting positions in related markets. On a risk/return percentage basis, spread gains are often higher than the gains on an outright. This is one case where insurance doesn’t just pay you back with peace of mind. It outright pays.
Also, the short position in heating oil went against us for a while, which may have forced us to exit the position if it weren’t offset by the long position in natural gas.