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Spread trading strategies overview

A lot of Forex traders use a plethora of trading indicators, others praise by technical or fundamental analysis, automatisation lovers are constantly trying to make an automatic money printing machine (but then again - who wouldn’t like that?) by programming expert advisors, there are also Martingale systems, neuron network, D’Alembert and many others… They all share one common flaw - these are all attempting to predict the market’s movement or react to current situation, e.g. are directional trading strategies. We’ll cover three of so-called market-neutral strategies based on quantitative mathematical principles, all being particular cases of spread trading trading system class. Each of these three is easily able to deliver that "statistical advantage" highly sought by "orthodox" traders. Okay, let’s go!

First I’d like to introduce you to the concept of spread instrument. Everything can be viewed as a spread instrument of the following formula:

SPRED=(w1*X1+...+wn*Xn)-(wn+1 *Xn+1+...+wn+m*Xn+m),

where Xj is the price of a trading symbol (say, EURUSD at 1.3550),
wj is its weight coefficient (most common is 1, of course).

A simple example, Forex arbitrage with two brokers! We’ve got arbitrage basics covered in our Forex arbitrage article, this formula will "deepen" your arbitrage knowledge and understanding. The formula looks approximately like that:

1*EURUSDAlpari - 1*EURUSDOanda.

See?

So, every pair, portfolio or arbitrage trading strategy is a particular case of spread trading. Just to set the theoretical ground…

Now, a brief guide to strategies which can be employed with Megatrader. We’ll cover three main ones:

  1. Pair trading
  2. Futures and currency spread trading
  3. Index/portfolio arbitrage
1. Pair trading

Perhaps the most popular out of the three.It’s a market-neutral (mostly) and rather versatile, but requires some math knowledge to achieve good results with.

The main idea - we’re having a pair of fundamentally (preferably) connected assets, like, the easiest example - two Google stocks, one giving a vote right (GOOGL), or a privileged one, and a common stock - GOOG:

Google stocks

One asset influences another, so their prices move in some kind of symmetry - as one plunges downward, another will likely follow and vice versa. This "symmetry" is called correlation.

Correlation is a term used in econometrics and statistics to measure two or more timeseries' mutual movement connection. Correlation is computed into the correlation coefficient, which ranges between -1 and +1. A correlation of +1, or full positive correlation, means that two timeseries (in our example - two securities' prices) move completely in accord one with another.Vice versa, a correlation of -1 (perfect negative correlation) shows that on a positive change of one timeseries we're having a negative change of a same fraction in another. In the case of zero correlation, the movements are having no correlation and are random e.g. have absolutely no connection.

Google stocks may be a little "biased", so let’s pick another example of different securities, like, GLD and SLW (both are mining companies):

GLD and SLW stocks

These have a correlation of 0.89 (pretty high!) and as can be seen, move in accord. Now, let’s adapt those to our spread formula:

1*GOLD - 1*SLW.

GLD - SLW spread

As can be seen, the resulting spread instrument is revolving around a mean value of ~47 dollars. So, we can just "buy" this spread instrument (by buying GOLD and selling SLW according to the formula) when it’s on highs and sell on mean reverting/low values. Of course, not everything is as simple as it looks, BUT, fortunately, our website has special web-services, Correlation and Pair matching, in its arsenal, that can prove helpful for every, especially novice, trader, for checking different financial assets on their correlation coefficient strength and select pair spreads suited for trading.

Now, on to our second strategy - futures and currency spread trading.

2. Futures and currency spread trading

It’s a very "large" strategy, with hundreds of combinations, and its advantage is that most combinations, being fundamental and/or seasonal, are well-known.

With Megatrader, futures spread trading using CFD contracts can be employed, which have both numerous advantages and some drawbacks compared to standard futures contracts, the advantages are being able to get a higher leverage when using CFD contracts and the ability to use fractional lots, both allowing for more effective trading capital usage, and the disadvantage is the OTC nature of CFD contracts (Over The Counter), they are mostly not regulated (however there already are exchange CFDs and DMA CFDs so this drawback is negligible).

So, you may ask - what kind of spreads can I trade? For example:

  1. Calendar spreads, using the same contract with different expiration dates - like Corn March vs September spread. However, usually the closest contracts are used.
  2. Intercommodity spread, such as Gold - Silver, or “grain” spread of wheat - corn. There are many known combinations, crack spreads, crush spreads (for example, Oil - Heating oil or Oil - Gas, also one notable example is Soy beans - Soy oil, e.g. commodities that depend on and influence each other - correlated commodities.)
  3. Intermarket spreads - this one shines when using CFDs, because it’s usually rather hard to employ at futures brokers. Notable examples can be SP500 - DAX, or other spreads.
  4. Currency spreads - mostly those are based on some countries’ economies’ connection, or a country being a big exporter/importer of some commodity and being "tied" to its price.

And many others…

Let’s have a deeper look at each of the spread types!

1. Calendar spreads are most commonly traded by fund managers, because they are a low-risk and moderate return strategy. They are also called "horizontal spreads" (if you look at a futures expiration calendar as a line, they indeed are spreaded horizontally, so that’s correct).

Here’s a common chart of a calendar spread:

oil futures calendar spread

It’s easy to assemble and easy to trade due to it’s naturally reverting nature. So, the basics are:

You should have an instrument which has expiration dates - most common one is a futures contract.

Usually, when you look at a next expiration contract (for example, looking at November’s expiration contract in July, before the closest one expires) - you see a lot of gaps, liquidity is absent resulting in crazy slippages. However, when approximately 30% time to closest contract’s expiration remains, traders and fund managers start to "roll" into the next contract (most seasonal and hedging traders operate high volumes so they cannot just press "Buy Market" button, they have do accumulate a trading position over time), liquidity starts to pour into next contract, spreads become better, gaps are almost nonexistant. So, it’s time to trade a calendar spread! It can be either made as a Closer-Further spread, or vice versa, a Further-Closer spread, it doesn’t matter.

Here’s how it looks in Megatrader:

Calendar spread in Megatrader

As can be seen, even the most simple trading strategies will work on such a synthetic instrument, truly a "buy low - sell high" situation! However, you should remember there may be some pitfalls: As it’s an easy to implement and trade strategy, there are lots of traders eager to "get a piece of that pie", so placing your server near your broker/exchange will possibly make your trading results much better.

2. Intercommodity and Intermarket spreads

Those are widely used in the futures market, because it’s literally flooded with fundamentally tied and thus highly correlated instruments: Brent and WTI oil, soybeans and soybean oil, cocoa/coffee/sugar, corn and wheat and many other combinations. Why are those correlated? It’s rather simple: think a bit - what would happen with soy oil (made from soy beans price, but that’s an insider secret, so don’t tell anyone!) in the case of a big soybean harvest? The soybean price will drop, of course, because offer will prevail over request. The companies will be able to purchase the beans for a lower price and produce "cheaper" soybean oil, which will also come in abundance. So, we’ve come to a conclusion that soybeans and soybean oil are highly correlated fundamentally.

There are several spread types: crack-spreads - between crude oil (WTI/Brent) and its products like heating oil and gasoline, crush spreads - spreads between soybeans and their products like soybean oil and soybean powder, commodity spreads between tied instruments like gold-silver, platinum-silver, palladium-silver and many other "metal" spreads, also currency spreads (can easily be done with Forex instruments instead of CFDs) and index spreads (like DOW-SP500, DAX-FTSE and other fundamentally correlated indexes). The variety is grand!

Let’s have a look at how an intercommodity spread, say, a crack spread:

crack spread chart

Pretty stationary, isn’t it? Most spread charts, when "made up" correctly are similar to that one.

3. Currency spreads

Forex market, being a "closed", or self-contained, system, implies cross-currency rates dependence on "major" currency exchange rates. In fact, Forex market is always supposed to be in full parity (if not - banks and marketmakers will guide it to parity very fast, be sure of that) to eliminate risk-free profit opportunities for market participants. However, it’s not the only interdepence on Forex. Because of some countries’ close economical relations (it’s not what you thought of!) their national currency rates start closely correlating, or in the case of a country being a major exporter/importer/producer of some exchange traded commodity - correlating with a futures commodity. Some examples:

WTI oil - usdcad

WTI oil and USDCAD…

auduasd - gold

AUDUSD and Gold (/GC or XAUUSD)…

Currency correlation can be viewed and analysed on Correlation page.

3. Index/portfolio arbitrage

Lots of complex instruments are traded on world’s exchanges. Instruments consisting of 2 or more constinuents. What are these? For example, the mighty DAX - it consists of 30 biggest Germany stocks. Or another example - Exchange Traded Funds, which can consist of 2-6000 instruments! Those are THE spread instruments. However, price discrepancies occur between the instrument itself and the portfolio it consists of, and they can be "created" synthetically.

First, to employ this strategy, one needs to know the constinuents of an instrument AND how are they calculated.

An index instrument can also be reproduced by our spread formula, for example, DAX will be as follows:

DAX = 0.1*EOA + 0.097*SIE + 0.078*ALV + 0.077*BAY + ... + 0.004*HNR1.

So the idea is as follows - we "create" an index of our own from the instruments and then do arbitrage-typed pair trading! The versatility is in the eye of the beholder: there are thousands of index instruments, and we can always "play" with the weights or constinuents, omit some, or interchange a constinuent for a highly-correlated asset. The possibilities are nearly endless.

Should I say why index arbitrage is the strategy of choice of a majority of hedge funds?

Let’s have a look at a possible chart of it (used XLE ETF fund - Energy Sector - versus a basket of stocks it consists of):

xle etf - basket of stocks

It can easily be seen reverting to its mean, zero. Pretty easy to trade, again, and quite possible to automate using Bollinger Bands.

Conclusion

As can be seen, these three strategies are:

  1. Not "rocket science", with a couple of days to grasp one’s mind around them, they can be implemented by a novice-to-intermediate trader.
  2. Quite low-risk, because you’re constantly hedged (one instrument against another) and mostly market-neutral.
  3. Potentially profitable - especially using leveraged CFDs, instruments funds don’t have much access to.
  4. Very variable - you don’t have to compete (mostly) with other people, as you do when trading arbitrage situations - you can just create "your own" index or pair spread and trade on your own.