Most traders say that markets nowadays have changed, become more volatile and chaotic. They are definitely harder to trade than 5 or 10 years ago. Classical trading, which worked a couple of years ago, now doesn’t. So most traders are in search of “the magical tool” to predict the markets, often using complicated mathematic formulas or even astrology. People are in search of a robust strategy, which will produce stable profit despite all the market changes. One of this strategies is spread trading.
Generally, spread is the difference of two or more (it’s called basket then) financial instruments. Each instrument is generally taken into calculation multiplied by a weight coefficient. If a negative weight is used, the instrument will be sold when buying the spread and the other way round.
Below is a clear example of spread trading. On the upper chart we can see futures on "Gazprom" (blue) and "Lukoil" (red) shares, on the bottom – spread chart of these two instruments. When prices diverge (“Lukoil” is cheaper), we sell the spread, thus we sell “Gazprom” and buy “Lukoil”. After the prices get close to each other (note the spread going to 0), we close our basket position getting about 600 points of profit.
One important thing when trading the basket is the correct choice of instruments. Often highly correlated instruments are used, for example stocks of companies which operate in the same inductry, futures with different expiry times, currencies which depend on each other. This hint gives the opportunity to achieve a market-neutral position, where trader profits from divergence and convergence of instruments’ prices.
Different types of spread trading are arbitrage trading and pair trading.
Arbitrage trading is based on trading the same instrument or similar ones. Depending on the tools used, arbitrage trading can be divided into several types:
– spatial arbitrage assumes the same instrument, traded on different exchanges, is used;
– equivalent arbitrage is using an instrument traded on different markets, for example stock – futures on this stock, or stock – ADR;
– Calendar arbitrage, where futures with different expiry dates are traded.
Pair trading is trading a “basket” of strictly two instruments. In contrast to arbitrage, where same instrument is traded, pair trading uses different instruments, but highly correlated ones. Typically, the paper is of one sector of the economy, for example, shares of "Apple" and "Google", or similar futures - oil and fuel oil, wheat, corn, etc.
One may ask: hey, why should I pay twice the commissions if I can just trade one instrument (or a cross pair like EURGBP)? The answer is – if properly constructed, the spread is much more predictable than the behavior of individual financial instruments. It is well known that the price of a financial instrument cannot be properly forecasted.Why? Because it’s affected by many external factors: the change in the political situation, economic news, natural disasters, etc. By trading a composite symbol, we remove the effects of unpredictable market factors, leaving only the effect of deeper, long-running factors reflecting the fundamental relationship between the instruments. Thus, instrument spread is proven to be more predictable than individual ones.
Another important advantage of spread trading is the fact that the spread, compared to individual instruments, is more stationary, less changing with time. Why is stationary so important to trade? The main problem for all developers of automated trading systems : a time series of individual financial instruments are inherently non-stationary, ie, of their development are changing with time, and, as a consequence, the trading system, proven in the past will not necessarily work as well in the future. But spread is the price ratio between instruments, which is much more stationary, thus a profitable spread trading system is more likely to be a robust system – not losing performance after some time.
Other advantages of spread trading are:
Lower risks. When trading convergence-divergence spread, both instruments are mutually hedged, and the net position remains neutral to the market. Therefore, risks of making a loss as a result of sudden unexpected market movements when trading spread is minimized. Thus, in comparison with classic trading strategies, spread trading carries a much lower risk.
A simple trading strategy. The basic spread trading strategy is very simple: let’s say we have a basket which goes in a range of highs-lows, always reverting to its mean price, meaning it’s cointegrated. It should just be bought when approaching its low range and sold when going near high values. It’s both easy to trade discretionally and by implementing into automatic trading robots.
Great potential. Nowadays, with the flood of online trading tools, even small-cap investors like most traders have access to a wide range of financial instruments with various trading. All these are opportunities to find a profitable system while maintaining low risk.
Thus, the spread trading is a powerful and deep trading strategy, which has many advantages. Not so long before, this strategy was only available to large investors and hedge funds. Now, is accessible to ordinary traders. Sheer statistics advocate for spread trading: nearly all traders, who tried trading baskets of instruments, never return to single instrument trading.
In our next article, Spread trading strategies overview, we will be going more in-depth on spread trading principle and its practical uses.