Spread trades between futures contracts present problems with equalizing the underlying prices. This is true with gold and silver because of the large differences in their cash and futures prices (see “Grain & cattle spreads: Finding an edge” (November 2011) and “Gold & silver: Always good options” (May 2011)). However, they also present opportunities.
Consider a recent trading day in September 2012. The cash prices for these commodities were gold, $1,755; silver, $33.98; wheat, $8.34 and corn, $7.36. Wheat and corn futures almost are interchangeable and frequently shift the lead in price size. On the other hand, gold and silver are spread trade partners that require some effort to put their prices on an equal level. This equalizing is not necessarily an insurmountable burden; however, it can create uncertainty in trades where the slightest mismatch can mean the difference between profit and loss.
A trading alternative that eliminates most price discrepancy by design is the exchange-traded note (ETN). Because the companies issuing ETNs design the securities to be based on underlying commodities in a format that is easily traded on stock exchanges, the prices are set such that they are a convenient size for most traders. These new securities also have percentage price changes approximating those of the commodities or futures contracts on which their prices are based. In the case of gold and silver ETNs, the traditional ratio between the metals (51.6 in the current market) has been eliminated so that their ETNs may be traded with comparable prices. The ETN prices on Sept. 21 for these ETNs were gold, $46.72; silver, $48.72; wheat, $22.77 and corn, $19.88.
“Futures and ETNs” (below) shows how closely the ETNs follow the price changes of a single futures contract for both corn and wheat, and gold and silver. December futures are used in this study for each of those markets. Keep in mind that most ETN index prices are based on a mix of cash commodities and futures, as well as Treasury securities and other variables. Thus, December futures are used simply to show the relatively close correlation between ETNs and as a dependable benchmark price.
The charts indicate that for the period of April to mid-September 2012, the spread between gold and silver was much wider and potentially more profitable than the distance at any time between wheat and corn. In the previous study of the gold-silver spread, gold was stable and silver was the more volatile member of the pair. The current chart confirms this relationship to a surprising extent. Starting in early April, by the end of June silver had a cumulative percent price decline of almost 20%, while gold was stable with almost zero price change. Silver rebounded by 25% to become equal to gold later in September.
Silver futures and the silver ETN move together. A spread or hedge trade of silver vs. gold could have used either the ETN or December futures with approximately equal results. With the tight relationship between each ETN and its associated futures contract, a spread between the ETN and December futures would be difficult for all four commodities. This differs from the potential ETN-futures spread noted for the livestock ETN, COW, which is based on a combination of live cattle and lean hog futures (“Trading cattle, hogs and ETNs,” November 2012). The potential of an ETN-futures spread is better in that case because the ETN is based on more than one underlying commodity, which at times allows larger differences for spread trading.
Dollar by dollar
Spreads valued in terms of dollars are depicted in “Wheat ETN – corn ETN” (below) and “Gold ETN – silver ETN” (below). The maximum difference for wheat and corn is between $4 and $1; otherwise the price difference is approximately $2 to $2.50. These small price spreads reflect the close connection between wheat and corn futures, carried into the ETN formulation.
The chart for the gold ETN minus silver ETN has a $7 maximum difference, between +$5 and –$2. Between these extremes, as shown on the chart, gold futures were stable while silver futures declined until a reversal occurred near the end of June 2012.
Volatilities of gold, silver, wheat and corn futures and ETNs are shown on “December call options” (below). Silver and wheat have the highest option price curves on Sept. 21, 2012. These are followed closely by calls on December corn futures and much less closely by December gold futures. Having viewed these charts, which clearly show the relatively high volatility of silver, wheat and corn, it is not surprising that these three — with cumulative percentage price changes of up to 50% — leave gold behind with lower volatility.
The call price curves are regression equations that produce predicted prices that match options market prices at each strike price. Each symbol on the “December call options” chart represents a separate strike price. As shown, all call option prices occur along curves that are determined by the market’s assessment of the relative price volatility of underlying futures contracts. The result is a market forecast at each instant during the trading day of upper and lower breakeven prices at the expiration date. Breakeven prices are those that result in no gain or loss from a delta trade: Long call options and short the underlying futures.
ETNs based on commodity futures tend to move in price at the same pace as their associated futures contracts. The result is that the percentage price spread forecast for the underlying at expiration also indicates the span of higher and lower prices expected for the ETN between the current time and expiration. In this way, the options market is forecasting a continuous stream of future price spreads for ETNs. As the underlying contracts expire and are replaced by new farther-out expirations, the forecast can be extended throughout the life or planned holding period of the ETN.
At this time, there are many ETNs and exchange-traded funds (ETFs) available with ETNs based on indexes of commodity and futures prices representing unsecured debt of the issuing institution. ETFs differ from ETNs in that they represent ownership of shares in real assets instead of index prices.
To illustrate the depth of securities now available for trading on stock exchanges, website goldetf.net lists four long gold ETNs, including the ETN used in this study, E-TRACS UBS Bloomberg CMCI Gold ETN. There also are double-long gold ETNs and double-short gold ETNs, each seeking to double the investment returns of the Deutsche Bank Liquid Commodity Index: Optimum Yield Gold. (Leveraged funds require extra care particularly in gold, but options and futures traders understand the risk in leverage.) The seventh security listed by goldetf.net is the Power Shares DB Gold Short ETN.
The silver ETN used here is E-TRACS UBS Bloomberg CMCI Silver ETN. Wheat and corn ETN data are listed by Bloomberg for WHEU and CONU. Along with gold, silver, wheat and corn ETN prices from Bloomberg, futures prices are found at Barchart.com. Analytical methods described should be applicable to any ETN or ETF whose price index is based on a single underlying asset.
Paul Cretien is an investment analyst and financial case writer. His email is PaulDCretien@aol.com.