Spread Trading Strategies Overview

A lot of traders have noticed the changes occuring in recent markets. Forex market had changed seriously, became unpredictable (even more so!) and chaotic, volatility and risks rising. Old, proven trading techniques that were profitable a few decades ago do not bring serious results. So, traders using outdated methods are often “defeated” by the market. In this situation, making profitable trades even under poor market conditions becomes as important as ever, preferably not threatening your deposit a lot, in contrast to the classical methods, which are sometimes very dangerous. In this article, we will talk about one of the following, modern and moderately safe ways spread trading.

To begin, let’s first consider what a spread is. A spread is considered as the difference between the value of two financial instruments’ baskets. Thus, a synthetic instrument (spread) is obtained and can be traded in the same way as a conventional financial asset, with the difference that when buying a spread a whole asset basket (first) is purchased with a simultaneous sale of the second one, and the sale of the spread is basically opening the opposite positions. The main idea in creating a spread is building a synthetic instrument that behaves as expected by its creator, e.g. fluctuating to some levels again and again. As a result, trading such a synthetic tool is usually much easier than usual, because (ideally) it’s just enough to buy and sell the spread on deviating from these mean values.

Here are the main spread trading strategies:

Pair trading;
Futures’ and currencies spreads;
Arbitrage portfolios and indexes.
1. Pair Trading

Pair trading is unique in a way that each instrument basket contains only one instrument. The simplest pair trading example can be as follows: one should find some assets associated with each other, having a large correlation, and make a spread out of these, ie calculate the difference between their prices based on assigned weighting coefficients. These assets will usually have a high probability of reverting to some mean value. Then it’s possible to trade it (the synthetical spread) the same way as a usual trading instrument, trying to buy low and sell high.

2. Futures’ and currencies spreads

Futures and Forex markets are very diverse – everyone can find and construct spread to trade for one’s liking. Here are the main ones:

Calendar spreads based on the same contract with different expiration dates. For example, spreads in May and October grain. But in practice, most often the closest expiration contracts are used for spread trading.
Intercommodity spreads , as an example, you can take gold and silver, or returning to the examples on grain corn. There’s truly a large variety of stable commodity pairs, some do even have their own name.
Intermarket spreads spreads, consisting of same assets traded on different exchanges (gold on Forex and CME or NYSE, for example).
Currency spreads purchase / sale of currency synthetic combinations.
3. Index \ arbitrage portfolio

This type of trade involves the creation of the spread between the indices and tools basket, “repeating” this index (most often just using some or all of index constinuent stocks/assets). There is a huge number of different indices on stock markets of the world, ETF funds and other “composite” instruments, so it’s a lot of room for creativity for spread creating – using different indices, instruments, weights, etc. So everything is in the trader’s power here!

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