Non-directional Ratio Spreads TradersCALM © "Dedicated to trading with good feelings."
	Introduction to Ratio Spreads A spread in the context of trading is the near simultaneous acquisition of two 'opposing' but similar value positions such as:       • purchase of Dow and sale of SP500 to equal value,       • purchase of Dow near future and sale of Dow far future. The objective is not to make money from any favourable move in the absolute price of a single security, but to unwind the spread position at a future date when the relative prices have moved favourably. The term 'ratio spread' is based on the idea, that one of the two sides needs to be adjusted by a ratio that allows for the relative prices and the relative value of one contract of each security (if different). There is a nice introduction to spreads by Joe Ross at introduction to spread trading. Not Just the Sum of Two Parts When discussing non-directional spreads, it is often asked "What is the underlying logic of each side." or "Can I not trade each side separately?" or "Can I leg into each side and wait to do the second leg if I think the second leg is going to move in my favor?" or some such question which sees a spread as merely the sum of two independent parts. These queries are mostly born of the requesters current comfort zone of trading one instrument (or multiple instruments independently) - rather than from comprehending the merits inherent in the concept of a non-directional ratio spread. This is best illustrated by reference to the wisdom of Solomon: Faced with two women, both claiming to be the mother of a baby - Solomon ordered the baby cut in half so each could have a half.     He rescinded his order when the real mother said the other women could have the whole child and judged in favour of the now identified real mother. So a spread is not separable except at the cost of killing the attributes of a spread.     So be a Solomon, and treat the spread as having most value as one entity, with a logic of its own, and stop thinking in terms of two separate parts. Attributes of Non-directional Ratio Spreads There are spreads and spreads - the ones we will be looking at are ratio spreads of two highly positively correlated markets - and where the ratio is chosen to give, allowing for contract sizes, a roughly zero net value of the spread so our pendulum like spread has an average value of zero. An example of two highly positively correlated markets might be the DOW Industrials and the S&P 500.     Anyone who can align two time series, having the same resolution, in the spreadsheet software 'Excel', and can employ the 'correl' function, has the technology to work out such correlations. Ignoring differences in contract sizes, about 1 times the DOW minus about 10 times the S&P 500 gives a ratio spread with a roughly zero net value - a nearly non-directional ratio spread. The phrase 'non-directional ratio spread of highly positively correlated' has many adjectives, all of which are significant.     Spreads which are not of highly correlated markets, and are based on a ratio that is not selected to remove most directional effects, behave in a very different manner. Non-directional ratio spreads of two highly positively correlated markets can (but not always) have the following attributes as suitable trading instruments for trend-followers, momentum players, volatility breakout players:       • higher reward to risk ratios than the component instruments,             • more movement per unit time,             • sometimes higher rates and longer periods of above 50% persistence,             • often lower drawdowns per unit profit,             • not dependent on specific absolute price stops,             • reduced risk of very large adverse move. Again non-directional ratio spreads of two highly positively correlated markets can (but not always) have the following attributes as suitable trading instruments for faders, market makers:       • higher reward to risk ratios than the component instruments,             • more movement per unit time,             • faster reducing rates of persistence,             • reduced risk of very large adverse move,             • higher position size possible for same percentage 'uncle point'. The reason for these positive characteristics is that ratio spreads of high positively correlated correlated instruments often have attributes that make them behave in similar manner to the perfect market - that is like a pendulum. To fully appreciate the behaviour of non-directional ratio spreads of highly correlated markets, compared to the behaviour of the individual instruments that make up such a spread, a reasonable understanding of persistence is required. What am I Trading with a Non-directional Ratio Spread? If you select the ratio to remove most of the directional bias, you are trading the relative movements, the differential volatility of two markets - so spreads often move more often than any one component instrument - as it only takes one market to make the spread move and they have to move exactly in tandem (adjusted for the ratio) for movement in both to become no movement in the ratio spread. Also as the two components are positively correlated, there will be a tendency to bounce back and overshoot - another profit opportunity for those who like to close and reverse. Sometimes, the relationship between the two component instruments of the spread can change materially over time, and an open position which you have held for an extended period may need adjusting - by either buying more of the relatively falling market or selling some of the out-performer, forcing you to buy low or sell high to re-balance at the new ratio.     Wonderful, you are forced to improve your situation, as is likely, the ratio returns to nearer its former value your expected profit is higher. Selecting the Ratio Let us use, for illustration, a ratio spread of the DOW and DAX. Let us assume that the DOW is at 9000 and the DAX at 3000.     Then the ratio which removes the directional component of the spread is 1 lot of DOW to every 3 lots of DAX. But this assumes the contract sizes of the two components are the same.     If the DOW contract you were trading was at $2 a point and the DAX at $12 a point, then the ratio to give zero directional component would be 2 lots of DOW to every 1 DAX lot. Trading Spreads Very rarely a ratio spread of two high positive correlation markets can be entered and exited as one trade and with margin offsets. More often the two components of a ratio spread have to be legged into and margin paid on both sides.     This has the merit of helping to stop some traders over-trade their account. When you have to leg into a spread trade, it makes sense, adjusted for the ratio being employed, to leg into the highest volatility leg first and then calmly place the other side of the spread.     Obviously you leg out of the more volatile part of the spread first for the same reason. The price being traded is the price of the spread - not the prices of the components.     For example, if you are a buyer of A and a seller of 2 lots of B, it makes little difference (except of course for margin purposes on options and stocks) if you either do:             • a) buy A at 100 and sell B at 50,             • b) buy A at 150 and sell B at 75. It is the net value of (A-2*B) that is the main thing and in these two example, the net value is zero is both cases.     Just like learning to drive is a complex task, but you eventually learn to drive home on auto-pilot, learning to think in terms of (A-2*B) as one price becomes automatic after a while. Counting the Profits and Losses Profitability is related to the calm quotient of the trader.     So if you are calmer, you tend to be more relaxed, see more opportunities and exploit them effectively. So you make more money on the same market movements, or at least make fewer losses. This helps to make you calmer and so can become a virtuous circle. As ratio spreads, if well chosen, tend to have higher reward to risk ratios than for the same trading approach on a single instrument, this helps you become calmer and starts the virtuous circle. But some traders have a 'death wish' and use the higher reward to risk ratio inherent in such spreads to increase position size to a point where the original risk they were experiencing is reintroduced or even exceeded.     There is little you can do to help such traders - they have to fail, and fail painfully to learn anything of value.     They have a learning deficit if you will, needing pain as a prompt to the learning process. Many successful traders I know:       • continually improve their reward to risk ratio (RtRR),             • lower position size until comfortable with any new approach,             • then use some of the improved RtRR to reduce their risk and               improve their feelings while trading,             • and use some of their improved RtRR to increase their reward. But they are still here - which is a key part of being successful - and they gain both financially and in terms of trading with good feelings from their improvements in RtRR.     They are the survivors who get rich steadily faster and faster while enjoying the process. Do not underestimate the importance of the enjoyment - for self-sabotage and low exploitation of opportunities often lies hidden behind any lack of enjoyment or stress or exercise of emotions of the maximal risk takers.