After having seen, in the previous article, what Spread Trading is, we now see some requirements. To make spread trading, the pair of instruments must be chosen appropriately. In general, the instruments must have precise characteristics. Here's what:
Correlation between financial instruments
The assets on which to operate in spread trading must be correlated, either directly or inversely. But what do we mean with the word correlation? The direct correlation implies that the two assets must have a similar trend, that is when one goes up the other goes up, when one goes down, the other usually goes down. The inverse correlation, on the other hand, provides that if one instrument goes up the other goes down and vice versa. To make spread trading both direct and inverse correlation is good.
In this regard, we review again the comparison between EurUsd and GbpUsd, where, expanding the observation from 01/01/2018 we can see how the two cross have a direct correlation (the prices of the two cross are different but FA Spread Trading Panel hooks them in the starting point so that what we see is the relative trend of the quotations that start from the same initial point)
To see an example of inverse correlation we can add a third cross, for example UsdCad.
We note immediately that the curve in red has a trend contrary to the other two. When these two rise UsdCad descends and vice versa. We can then reverse UsdCad by clicking on Reverse checkbox to consider that the cross is inversely correlated.
You can understand that UsdCad is inversely correlated from the fact that the currency Usd is found in the first part of the cross unlike the other two cross that report it in the final part. The fact of having an inverse correlation will also have consequences if you decide to do Spread Trading. In fact, in presence of direct correlation, bet on the closure of spread means opening a Buy on one side and a Sell on the other, in the case of reverse correlation you must open two positions of the same type Buy-Buy or Sell-Sell, possibly varying lots to bet more on one or the other and still have coverage.
Statistically there are correlations in all markets, and therefore both among the commodities, both among the indices, among the shares, between gold, silver, oil, currencies, etc ... The correlation also exists between different markets such as between dollar and gold, or oil etc ... Obviously the correlation also varies based on the timeframe that we consider and could be strong with big timeframe and small with small timeframe
However, there are sites that provide always updated data on the correlations between currencies and / or indices, such as MyFXBook.
As we said doing Spread Trading means working simultaneously on multiple financial instruments, usually directly correlated. The gain on one instrument is mitigated by the loss on the other (normally) and ultimately the cumulative result is given by the difference in performance between the two instruments. This means that if the two instruments were perfectly correlated (correlation index equal to 1) it would not make sense to make Spread Trading because the gains on one instrument would be completely loss by the losses on the other side with cumulative result equal to 0 (even with loss if we consider the commissions). To make spread trading, therefore, is required a certain market volatility. In fact, in presence of large volatility, often one of the two tools moves much more than what happens to the other (it is said that it outperforms / underperforms the other). This leads to significant variations in the spread and therefore to significant gains or losses. The bet here is to understand in advance which tool will move the most.
Inter Market and Intra Market Spread trading
As we said in the previous article the spread trading in the forex takes on a special meaning (and for some, not me, it may not make sense). Alternatively, you could still consider choosing assets from different markets, such as a currency and an index, or a currency and a commodity (like UsdCad and Gold or Silver). We speak in this case of Inter Market Spread Trading unlike the Intra Market Spread Trading that occurs when operating within the same market. Correlations in Inter Market exist and here I show some:
To make comparable instruments with very different quotation and with a very different value of the pip (ie the smallest variation in the quotation value), the graphs are normalized with the value of the pip of the graph on which the EA is hooked (in this case the graph EurUsd). If the value of the pip found by the EA is not the correct one, you can adjust it through the text box next to the symbol name. As in this case where I modified the silver pip value
Timeframe for Spread Trading
Regarding the timeframe there is no particular constraint so we can use the timeframe we prefer. We can see that by going from big timeframe to smaller timeframe, the curves become more detailed but continue to have the same trend. For asset selection we can look at the existing correlation in large timeframe, from H1 in up
Advantages and Disadvantages
Spread Trading has several advantages, among which the most important one is to expose to the risk of limited losses. This is because we operate on the differential between two financial instruments correlated and therefore with similar trends. This should in some way protect us from the ruinous market crashes that can always happen and which would be offset (on the one hand you lose and on the other you gain leading to net results limited in profit or loss). These falls could instead be catastrophic in classic trading if we were in the wrong direction (exposed in Buy in a collapsing asset).
Then it must be said that you can also gain during the lateral phases of the market because often one of the two assets moves faster than the other and if you set a cumulative target there will be times when it is reached.
All that glitters is not all gold. We have, as mentioned previously, also some disadvantages. Focusing on the spread of correlated instruments, we will have not too large variations, and consequently also the profit margins will be more limited. Then we pay more commissions, since we have to open double the positions. And finally, if we fail the choice of assets we may find ourselves exposed in the wrong direction in both financial instruments by double-overloading our account.
Spread trading is a good trading technique but you need to pay close attention and get a little confidence. The most important thing is the selection and analysis of financial instruments because they need to be correlated. But the correct choice is not enough. It is necessary to understand and predict how the spread (between the chosen instruments) will evolve and this can be done by evaluating the markets or using indicators. We will see this aspect in the next article.
As always, the pros and cons must be evaluated. My personal opinion is that it's worth it. I wait for your comments to know what you think.
I'll meet you at the next article and I invite you to visit my Facebook page.