Finding a market’s shadow provides a great opportunity to create profitable spread trades.
Shadow prices occur when the price of one futures contract attempts to match the movements of another contract. The one following might be called the junior member of the pair – trying to keep up with the senior member by responding to price changes with more volatile movements of its own.
Notable shadow pricing pairs include gold and silver, in which silver responds to gold, and the euro and Swiss franc where the franc was tied to the euro because of Switzerland’s central bank policy of pegging the franc to no more than 1.2 euro.
Shadow contracts are more volatile than the senior members, tending to move too far in each direction. A greater volatility of shadows is recognized by the options market as shown by their higher call price curves.
Exchange-traded funds (ETF) are natural shadows. All ETFs have the objective of reflecting the price movements of underlying assets and, in doing so, frequently provide price differences that can be traded with low- risk spreads.
Trading ETF shadow prices takes advantage of both larger volatilities; in the shadow and its corresponding exchange traded fund. For example, silver as a shadow of gold is more volatile than gold. The silver ETF, SLV, should magnify the volatility difference. “Gold and silver, iAU and SLV” (left), shows that the SLV is, in turn, more volatile than the gold ETF, iAU, reaching up to 25% higher cumulative percentage price change before falling back. The chart indicates a 15% difference for a possible spread trade between SLV and iAU. Because the ETFs reflect price movements in the underlying silver and gold futures contracts, the spreads on the chart provide assistance in the timing of trades in related futures and options.
“WEAT and CORN” (below) shows the price changes for the ETFs representing — no surprise — wheat and corn. The chart shows very little difference in volatilities between the two ETFs, but does indicate an approximate 10% spread that may be traded, based on the close price movements from March through June of 2016.
Between the two cattle related ETFs, LSTK (the iPath Pure Beta Livestock exchange-traded note) tracks and COW (the iPath Bloomberg Livestock Sub index total return exchange-traded note), the current price movements in March 2017 are virtually equal (see “LSTK & COW,” below).
Earlier spreads from June through August 2017 were due to LSTK lagging behind COW and then catching up with the decline in price. The two adjustments in price make it appear that LSTK is the more volatile member of the pair, and are potential price changes to watch for if there is another decline in COW’s price. LSTK is shown to be the shadow of COW.