Random Walk Trading – 1-5 Spread
1-5 Spread
Running time is: 2 hours 41 minutes
The 1-5 spread can expand in a bullish or bearish market under the assumption that the SPX outperforms the OEX. In a bearish market, we expect the OEX to fall more than the SPX (brick and leaf example) causing the spread to expand. In a bull market, the spread expands because the SPX tends to generally outperform the OEX.
On average that in bullish trends the SPX rises at a faster rate than the OEX and in bearish trends you will see that the SPX falls faster than the OEX (or outperforms to the downside).
The general rules are just that, general rules. By no means does this mean that the spread always expands when the markets are rising, nor does it always contract when the markets are falling. I think you have to forget about the general rules for minute if you want to think about this example from that page.
They are just saying they have an opinion that the market will likely fall but that the cash spread will likely expand. This is the opposite of the general rule, and it can certainly happen. Suppose the general market is bearish but not overly so. Also suppose that one of the largest companies like XOM came out with some news that is dragging itself, along with its sector, down.
Aren’t some of the largest companies in the world oil companies? So in the book recall when it discusses how the movement of the largest companies has a greater effect on the 100 stocks of the OEX than the 500 stocks of the SPX? (see around p. 8-9) This gives us the scenario where the market is bearish but the OEX would be falling at a faster rate than the SPX.
So if you wanted to trade a scenario like the one above, with the market falling but the cash spread actually expanding they are bang on to say that you would want to get long the OEX put spread and short the SPX put spreads. If the cash spread is expanding it is because the SPX is rising at a faster rate than the OEX is OR (like in the example you are looking at) THE OEX IS FALLING AT A FASTER RATE THAN THE SPX. Both of those things would cause an expansion in the cash spread.
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