FROM THE ARCHIVES: What is Spread Trading?

I wrote this post in the early days of the blog.  Good recap of what is technically involved in spread trading and how to construct a position.

Instead of looking at the flat-price action of an instrument and betting if it will go up or down, spread traders look at the difference, or spread, between two or more assets.  Flat-price traders go long or short and profit if the position goes their way and lose if it goes against them.  Spreaders take both a long and a short position and have multiple ways that their spread can create a profit or loss.  Spreaders are concerned with the relative value between two instruments.  They make or lose money if the price differential of their spread increases or decreases.

I’m usually focused on correlated equity pairs when I refer to spreads, but many spread traders operate in different markets.  They trade intra-market products such as futures calendar spreads.  Others trade inter-market spreads of cross exchange listed products such as grain and metals futures.  Lastly, there are the cross commodity spreaders trading different products against one another such as the various components of the energy or fixed-income world, eg. 5Y Notes vs 10Y Notes.

What is a Correlated Equity Pair?  These are two stocks that for whatever reason trade similarly to one another.  They may be in the same sector or industry, or have some fundamental reason to be correlated.  Or they may have some other not-so-obvious reason that they trade together.  The point is that they are statistically correlated to one another.  Lots of people call this ‘Pair Trading’, I use the terms interchangeably.

Because you take both a long and a short position in a spread trade, you reduce some of the market risk.  This’s not to say that spread trading isn’t risky.  In fact some spread trades have significantly more risk than straight directional bets.  You simply trade one risk for another.  In the case of equity pairs, you are trading some market risk for company-specific risk, or in the case of some ETFs, profile risk.  You are not as concerned with the absolute value of the S&P 500 if you are long the DIA and short the IWM.  You are more concerned with the relative performance of large cap industrials  (DIA) against the small caps (IWM).  You would expect if the broad market is down that both industrial stocks and small cap stocks will also be down, albeit in different magnitudes.  If both the DIA and IWM trade lower with the broad market you will lose money on the long, but make money on the short.  If DIA is down less than IWM, then the spread will gain in value and you will make money.  On the other hand, if DIA is down more than IWM the spread will reduce in value and you will lose money.

Here is all of the ways being long DIA and short IWM can make money.  In each case the opposite scenario will lose money.

  • DIA and go up and IWM can go down
  • DIA can go up and IWM can stay the same
  • DIA and IWM both go up but DIA goes up more then IWM
  • DIA stays the same and IWM goes down
  • DIA and IWM both go down but DIA loses less than IWM

If you were to talk about the long DIA, short IWM trade you could say that you are long the spread.  It all depends on the way you express the spread as a mathematical formula.  I will discuss this in a future post.  In all the scenarios detailed above a spread charted as DIA (minus) IWM would appear to be moving up from the bottom left to the upper right of the chart.  Take a second to visualize this process.  For those familiar with the concept, this is basic but for those new to these principals, it will take a bit to get it straight in your mind.

Because spread traders are concerned with the relative value of instruments they can free themselves of many of the constraints of traditional flat-price trading.  Traditional technical analysis is less prevalent in spread trading.  In the most simplistic sense spreaders are looking for what is cheap and what is expensive.  You want to buy what is relatively cheap and sell/short what is relatively expensive.  The overall market conditions can sometimes force flat-price directional traders out of the market based on their biases.  They may feel that they can only trade volatility or they identify themselves as a strictly a  “bull” or a “bear” and not trade in light of what they view are unfavorable conditions.   As a spreader you must adapt to the market, but there are always opportunities in relative value.

Spread trading is simple and complicated at the same time.  It opens up many more trading opportunities, but it requires a bit of an open mind and some different skills for success.

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