How to Learn to Spread Trade
Spread trading is about finding the relative outperforming stock between two stocks in the same industry. Spread trading is also used in commodity and options trading to arbitrage differences in the same stock with different maturities or different strike prices. Spread trading is conducted differently in the United States than in the United Kingdom. Understand that spread trading reduces the risk from the general trend of the market. Traders must measure the prospects of just the two securities being traded.
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Instructions
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Know that UK spread trading involves a bet as to which of two securities will outperform the other. Use the British model, where a spread trader does not go long or short on a security, but simply bets on the outcome. Understand that the United States uses the idea of relative out-performance by using a technique similar to arbitrage where two distinct securities are simultaneously traded long and short.
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Choose two stocks in the same industry that are close competitors. Examine the relative merits of both and decide which stock will outperform the other over a specific time period. Use the American system and buy the stock you believe will outperform the other. Sell the stock you believe will under perform. Know that this is technically an arbitrage because you had to buy and sell two stocks. Measure the difference in performance each day and track the results in your spreadsheet.
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Spread trade two stocks as described above, but be certain to weight equal amounts of dollars in each stock. If the stock you are long costs $10 and the stock you are short costs $5 then short twice as much stock as you buy; this is called equal weight spread trading.
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Use commodity or option trading for time value spread trading. Choose an option or commodity you believe will rise in value. Buy a long position in a short maturity and sell a longer term maturity. The short maturity will rise faster in value than the long maturity. At the maturity of the short call sell both positions and net the profit.
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Use a form of price spread trading for options. Choose the direction of one stock and trade how much it will move. Buy a stock and sell an option (also known as a covered call). Know that the trader is betting that a stock will rise but not up to the option strike price. Sell the stock at the option maturity date and keep the stock profit and premium received from the sale of the call. If the stock price exceeds the strike price you will lose the stock at the strike price no matter how further it goes.
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Understand that any trade involving the time value of the same security or the relative difference of two stocks can be considered a spread trade. Spread trading exists to take advantage of small price discrepancies and avoid general market movements.
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Tips & Warnings
Always practice trade and test your theories carefully under a variety of market conditions.
Avoid trading with margin until you are a successful trader. Margin trading can affect your trust in your own system because of the greater swing in your trading account values.
References
Resources
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