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.

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 , ensuring your earnings are virtually immune to significant price movements in an asset. Spread trading itself is a swing trading strategy, as a trader can hold a position for months and still exit with a significant profit at the right moment.

Typically, these types of systems allow you to earn 5-10 percent per month, which is why they have not gained much popularity in the Forex market.

The Basics of Spread Trading Strategy

As mentioned earlier, spread trading is a type of hedging involving two opposing assets. Hedging generally involves opening two opposing orders on the underlying and target instruments. For example, buying a stock and simultaneously selling a CFD on that stock for the same amount.

The purpose of this type of hedging is to mitigate risks from falling stock prices, with the added bonus of receiving dividends. Spread trading primarily involves assets from the same market, but they must be different.

So, the main goal when trading spreads is to select two assets in the same area with a very high correlation. Typically, the best assets are stocks in the same area, such as the stock of a growth leader and its primary competitor (AMD and Intel).

Naturally, when the economy is booming, the charts of these stocks will go up at the same time, which is actually the whole point of the strategy.

The second step after selecting 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 a cola.

However, there are similar places in your city, such as MasterCook or Chicken Hut, where you can get the same fries and a hamburger with a Coke, but at a slightly lower price. In fact, if you compare these places, you'll clearly see that McDonald's is the clear winner between the two.

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

You might say it's simply impossible to squeeze a profit out of such a trade, since stocks from the same sector will move in unison, and we'll only lose out on commissions. However, the essence of spread trading is that we choose a strong stock over a weaker one for a reason.

Principles of earning strategy.

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

So, let's imagine you bought McDonald's shares for $5,000 and sold its closest competitor's shares for the same amount. If the economy rises, you'll gain 10 percent on your McDonald's buy, or $500, while simultaneously losing 6 percent by selling your closest competitor's shares, or $300. 

With this trade, you'll earn a profit of $500 - $300 = $200 with virtually no risk, and the profit is your spread. You might ask, what if the economy were to decline and your positions remained in the same direction?.

In this situation, we also profit because investors are the last to dump more expensive stocks, which isn't the case with competitors in the same industry. In the event of a severe economic downturn, we would lose 6 percent on McDonald's shares and gain 10 percent on our short position on our main competitor.

If we do the math, no matter where the price goes, we would have earned our $200.

In conclusion, I'd like to point out that spread trading is based on the simple psychology of human behavior and greed. However, there is one major drawback to using this method.

It is therefore crucial to find instruments that have a strong correlation coefficient , and when choosing a position, it is important not to make a mistake with a strong or weak asset, since in the event of such a mistake, no matter where the price goes, the result may be negative.