Spread Trading. Strategy and concrete examples

What is spread trading?

The term Spread Trading means a particular way of to do trading. It is normally based on two assets (hence also the name of Pair Trading) chosen among currencies, indices, commodities, etc. Instead of focusing on a single financial instrument, and bet on its rise or fall, this particular trading strategy focuses on increasing / reducing of the difference between the performance of the two financial instruments chosen. For those who are just approaching trading this strategy might seem difficult, but with some examples it will become clear that it is not.

To better understand what it means to do Spread Trading we start from the classic trading on a single instrument.

We open a graph, for example, the classic EurUsd.

Trading Classico

Those who do classic trading will usually look for input signals through the most disparate techniques. Some use an indicator, some more than one, others base their choice on economic news that somehow impacts the markets. Then there are those who rely on signals provided by professional traders (or presumed :-)). And here we should understand if these signals are valid or not, or anyway more valid than their own. Impossible to know if not after a few months of use. Ah already there are historians, but who assures us that over 2, 3 accounts in profit do not fly over 20, or 30 accounts zeroed or closed at a loss? Beyond the whole problem, however, it is still the same: it is necessary to foresee future movements. Once the prediction has been made, for example of a rise, we will earn every time the forecast is correct, and we will lose when the prediction is wrong.

As I said before, to make Spread Trading you need to consider 2 financial instruments for which we also open the graph GbpUsd same timeframe.

As we can see the trend that the two instruments have had is similar. To see the relative trend of the two graphs we can use the software FA Spread Trading Panel 2 that allows us to draw on the same chart 2 or more financial instruments by hooking them in a specific point.

If you want, you can click on the green button to ask the software to draw directly on the graph below. We minimize the graphical interface and, to see better, change the background color

From the overlapping of the two graphs we see that the two instruments have a similar trend but one of them. EurUsd, is performing a little 'better (at the moment) . Making Spread Trading means making a prediction about the difference in performance between these two instruments. Do we expect the curves to move closer together, and therefore a narrowing of the spread, or do we expect the curves to move away (ie an increase in the spread)?

Suppose we want to bet on the narrowing of the spread (because for example I notice that the curves were normally very close and this distancing is anomalous and it will be covered shortly). In this case I will open a SHORT position on EurUsded and a LONG on GbpUsd.

FA Spread Trading Panel 2 also allows us to open orders, group them and assign them a target (and close them when the target is reached up).

With this technique, in which cases will we obtain a profit? Analyzing what can happen, we will immediately realize the advantages and disadvantages of Spread Trading

Let's start by saying that I get a profit if:
1) the two instruments have an upward trend with GbpUsd which rises more than EurUsd
2) the two instruments have a downward trend with GbpUsd falling less than EurUsd
3) GbpUsd has a bullish trend and EurUsd a downward trend.

If there is no trend, the two instruments will have oscillations up and down and there will be times when the cumulative profit is positive and others where it is negative. By setting a target, when the profit touches that value, FA Spread Trading Panel 2 will close the positions.

Obviously there is also the case in which, having focused on a narrowing of the spread, the forecast is wrong and the two instruments continue to move away. In this case we get a loss generated by both positions (and we will be exposed on two instruments in the wrong direction)

Concluding this section we can say that with Spread Trading the gain does NOT depend more on "how much" the individual instrument has gone up / down, but on how the difference (in fact the spread) has changed between the two financial instruments.

The example shows why spread trading is a MARKET NEUTRAL strategy, that is non-directional and you can make a profit regardless of whether the market is bullish, bearish or without trend.

Spread Trading sul Forex

In the example above we used EurUsd and GbpUsd where the USD currency is present in both instruments. In reality, what we have done is to focus on the EurGbp cross (that exists between the tools available in the MetaTrader 4 and 5 platforms). We have indeed bet on the fact that the performance of Gbp compared to Usd was better than Eur's performance compared to Usd. This translates into betting that the EurGbp cross goes down. Someone could say at this point that it is better to trade the EurGbp exchange directly and is not entirely wrong. But here we go back to what I said at the beginning: how to find the signals for open position for a particular financial instrument? In our example, this could be a possibility. To betray EurGbp and choose what to bet on, I can look at the spread between EurUsd and GbpUsd.
In some cases, however, there is convenience in making spread trading also if the two cross involving the same currency. I can always look at the spread between the two instruments as an indicator to get information about the tool that works early or late and decide to open accordingly. In the event that the prediction is incorrect and the position goes into loss we can decide to cover ourselves with further losses by opening a contrary position on the other instrument that at this point will be operating in advance (hedging operation).

The spread between the two instruments thus becomes an instrument for deriving entry signals. Obviously the strategies that can be put in place are many and I will present some in the next articles. For this reason I invite you to register, if you have not already done so.

Conclusions

Spread trading is an interesting trading technique that requires great attention. The crucial aspect is the choice of instruments, which must be correlated. Making the wrong choice of assets will have consequences on the outcome of spread trading.

In Forex it is possible to make spread trading even if in a way that deviates a bit from the traditional method and we can look at the spread as an input signal generator. Strategies as usual can be the most varied.

For more information see the next article on the requirements

I'll meet you at the next article and I invite you to visit my Facebook page.

Good trading!

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