Spread trading strategy

Every beginner or outsider, having heard the word exchange and trading, implies the purchase or sale of a certain asset in order to make money on the difference in prices.

Actually, every trader who has never heard of trading on spreads conducts exactly this kind of trading in the classical sense, where he tries to buy or sell an asset in order to make money on its intraday movement.

Simply put, for 90 percent of traders, the trading process comes down to mere speculation. However, it is speculative trading on one asset that is considered the riskiest method and approach when working on the stock exchange.

After all, everything is quite simple, if you entered a buy position and the price went up 100 points, you earned money, and if the price went down, you lost those 100 points.

Actually, this is where the high risk lies, and if we take into account leverage and various commissions, the risk becomes much higher than we expected.

A spread trading strategy is a special approach to risk hedging , thanks to which your earnings are practically not subject to any strong price changes in the asset. The spread trading tactic itself is swing, since a trader can hold a position for months and at the right moment come out with a good profit.

As a rule, these types of systems allow you to earn 5-10 percent per month, so they have not gained much popularity in the Forex market.

The basis of a spread trading strategy

As already mentioned, trading on spreads is a kind of hedging that involves two differently directed assets. Actually, all hedging means opening two differently directed orders for the base and original instrument; for example, we buy a share and at the same time sell a CFD for this share in the same monetary equivalent.

The purpose of such hedging is to neutralize risks when stock prices fall, and to receive dividends as a pleasant bonus. When trading spreads, assets are mainly taken from one area, but they must be different.

So, the main task when trading spreads is to select two assets from the same area with a very high level of correlation. As a rule, the best assets are stocks in the same field, for example the stock of the industry leader and its first competitor (AMD and Intel).

Naturally, when the economy is thriving, the charts of these stocks will simultaneously go up, which is the whole essence of the strategy.

The second step after choosing assets from one industry, namely the leader and competitor, is to clearly determine which of the shares is much stronger.

For example, you all know very well about such a famous fast food establishment as McDonald's where you can buy French fries and a hamburger with cola.

However, there are similar establishments in your city, for example Master Cook or Chicken Hut, where you can buy the same potatoes and a hamburger with cola, where the price is a little lower. Actually, if you compare these establishments, you clearly understand that McDonald's is the clear leader regarding the two proposed establishments.

The third step after identifying the leader and the competitor is to split your sum equally in order to buy the shares of the leader and at the same moment sell the shares of the weaker competitor with the same amount of money.

You will probably say that it is simply impossible to squeeze out a profit from such an operation, since shares from one sector will move in unison, and we will only lose on commissions. However, the essence of spread trading is that we choose a strong stock and a weaker one for a reason.

Principles of earning strategy.

With further economic growth, the leader's share will gain momentum much faster; for example, the promoted McDonald's will grow by 10 percent, and its weaker competitor by only 6 percent.

So, let’s imagine that you bought shares of McDonald’s for five thousand dollars and sold shares of its closest competitor for the same amount. If the economy grows from a long position on McDonald's stock, you will earn 10 percent, which will be $500, and at the same time you will lose 6 percent due to the sale of shares of your closest competitor, which will be $300.  

During such an operation, you will receive a profit of 500-300 = 200 dollars with virtually no risk, and the profit is your spread. You will probably say, what if there was an economic downturn, but the positions remained in the same direction.

In this situation, we also make money, since investors are the last to get rid of more expensive shares, which cannot be said about competitors in the same industry. In the event of a severe economic downturn, we would lose 6 percent on McDonald's stock and gain 10 percent on our short position on our main competitor.

If we calculate it mathematically, then no matter where the price goes, in the end we would earn our 200 dollars.

In conclusion, I would like to note that spread trading is based on the simple psychology of human behavior and greed. However, there is one huge disadvantage when working using this method.

So it is very important to find instruments that will have a strong correlation coefficient , while when choosing a position you must not make a mistake with a strong and weak asset, since in the event of such a mistake, no matter where the price goes, the result may be negative.