Spread Trading Strategies: An Introduction

Alexander Demin
 


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A growing number of traders note that the market recently has changed, becoming more and more chaotic and less predictable, with increased volatility and, subsequently, risks. Traditional trading strategies, generating income for numerous generations of traders in the past, are sometimes failing to adapt to the current environment. As a result, traders are focusing on guessing market direction or future trends on a single financial instrument, often dooming themselves to failure. Thus, methods allowing the trader to obtain a relatively stable profit regardless of market direction are becoming increasingly popular. One of these trading approaches, known as spread trading, will be briefly covered below.

A spread is basically a delta (difference) between two or more similar (usually) in their characteristics or movement patterns asset baskets. The value of an asset basket is calculated by the value of its constinuents, taking their “weight" (coefficient) into account. The basic idea of spread trading is extracting income from spread movements, namely “narrowing" or “widening". Buying a spread is performing a purchase of the first basket (basically instruments with positive “weights") and going short on the second basket. Selling a spread involves a sale of the first basket with a simultaneous purchase of the second basket.

The most important factor in ensuring one's success in spread trading is correct selection of instrument combinations which make up the spread. The main objective is selectinga combination of assets for the spread to have been oscillating inside a certain, preferably constant, range, for some time. To achieve this goal, usually some highly correlated assets, such as stocks belonging to the same economic sector, or one company's stock tickers from various stock exchanges (that's right, it's spatial or cross-exchange arbitrage, being a case of spread trading), shares and derivatives, futures with different expiration dates (calendar arbitrage), etc. are all considered while building a spread. In this case the first basket's potentially adverse price movements will be compensated and hedged by the movements of the second group, and the total market exposure would remain mostly neutral, hence the name - market-neutral trading.

There's a wide variety of different spread trading strategies. Futures markets are overflown by closely related and thus correlated instruments: Brent and WTI crude oi, soybean oil and flour, cocoa, coffee and sugar, corn and wheat and many other combinations. As a rule, these assets are correlated on a fundamental level, because of the products’ supply-demand, interchangeability, logistic chains’ similarity, dependence on weather etc. There are many “well-known" spreads, some of them even acquired “nicknames", for example, crack spreads - oil and oil products like gasoline spread, named after oil refining process - cracking, crush spreads - the one between soybeans and its products: flour and soy oil, stock index spreads, currency spreads. Also, metal spreads such as gold and silver, platinum and silver, silver-palladium, platinum-palladium, and others are ever-popular - metals have existed for a long time and will continue to be used in jewellery and industry.

As can be seen from our short overview, spread trading provides an excellent opportunity to gain even on volatile, unpredictable markets with minimal risk. Thanks to the enormous variability, each trader is able to build a spread asset of his own and trade it. Learn more about the vast world of spread trading strategies and their implementation here: megatrader.org.

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