What does the market think about a certain stock or commodity? Sometimes it can be hard to tell! One tool that can shed light on what’s going on in the markets is the spread. The spread is the difference in price between two adjacent markets (i.e. the opening and closing prices of two straight-ahead contracts or the difference in open and close prices of two European or two American style spreads).
Consider these examples:
- The S&P 500 (SP500) is trading at 1,550 at the moment and the EURO STOXX 50 (STOXX) is trading at 1,560. The difference is 10 (1,550–1,560 = 10). In this case, the market believes that the price of the SP500 will move higher than that of the EURO STOXX 50 over the next hour.
- Gold, which recently saw its price skyrocket, is trading at US$1,720 per ounce and the U.S. dollar, which normally serves as a safe-haven for gold investors, is trading at 107.80 (the ‘gold/dollar’ spread is therefore -17.20 or almost -2.5 times its normal level). The euro is slightly weaker and is trading at $1.6919, which gives the gold/dollar spread a negative value of -15.81. In this case, the market is anticipating a dollar price decline against the gold price over the next hour, a so-called dollar ‘risk-on’ scenario.
- Wheat is one of the most popular commodities to speculate on because it is one of the most active markets. At the moment, wheat is trading at USD 6.71 per bushel, which is a huge spread over its current price of USD 4.50. One reason for the spread is the market’s perception that Russia, the world’s fifth-largest producer of wheat, will export more of the grain in 2018 than usual. If Russia’s wheat export season starts early, it could mean higher demand and therefore lower prices in the coming months. Short-term traders seeking to profit from rising wheat prices might see a potential buying opportunity in the near future.
The spreads are not all bad news though! For instance, suppose both the SP500 and the STOXX reach their respective target prices of 1,550 and 1,560 at the same time, which is obviously highly unlikely. In this case, betting on the SP500–STOXX spread would guarantee a profit of about $10 per hour (because 1,550–1,560 = $10 and $10 multiplied by the number of hours in an hour means a potential profit of $10 per hour). Similarly, if Russia stops exporting wheat or the dollar drops in value, the market’s perception of a safe-haven for the dollar could reverse, which in turn would result in a rise in the price of the SP500. In this case, short-term speculators would be able to make a fortune by betting on the SP500 price rise over the next hour.
Why Do Markets Become Favorites For Money Management?
In general, short-term movements in the market tend to be followed by lengthy periods of stability or regression. Since the late 2000s, this tendency has been amplified because of three key factors: the growing use of data-driven or ‘digital’ trading, the abundance of easily accessible leverage, and the evolution of high-frequency or ‘HFT’ (for ‘high-frequency trading’) algorithms. Simply put, HFT algorithms allow speculators to exploit small price differentials and send orders to the market much more quickly than their traditional counterparts could.
The result is that short-term market fluctuations often now have a significant impact on long-term price trends. This is especially noticeable in emerging markets, where the overnight shutdown of a stock exchange can cause a significant correction in the commodity’s or stock’s price. It is also important to note that in many cases, high-frequency algorithms allow short-term traders to open up very profitable positions even during extremely volatile market conditions, as we have seen in the recent past.
How Important Is It to Keep Up With The Times?
One important factor that affects the market’s perception of a stock or commodity is the current economic climate. When the economic environment turns bad, so too does the market’s perception of the underlying asset. This is because most people associate bad economic times with a need for safe-havens, which in turn leads to an increase in the prices of the underlying assets. For example, after the 2008 financial crisis, the price of oil soared because most people perceived that oil exporters such as Russia and Saudi Arabia needed a safe-haven for their money.
Similarly, the price of gold shot up after the Great Recession of 2008–2009 because many people perceived that money needed to be saved during the down-turn in the global economy. It is therefore vital that you are aware of developments in the world of economics if you want to remain competitive as a money manager.
The Final Takeaway
In order to maximize the potential for profit from short-term bets, it is important to remain abreast of the economic trends in your chosen investment area. This is especially important when selecting long and short-term investment opportunities. For instance, if you are trading oil, you will want to ensure that you are taking advantage of the current situation and are not caught off-guard by events. The same principle goes for every other market or underlying asset you might consider adding to your investment portfolio.