Spread trading is a more advanced stock trading strategy that involves the simultaneous buying and selling of different stocks. Unlike traditional long-only or short-only strategies, spread trading targets the price differential between two stocks, as opposed to trading on broader market trends.
This approach permits investments to trade on more complex market trends as opposed to just the broad market directionality.
Spread Trading Strategies
Spread trading strategies can be broadly categorized into two main types: mean reversion trades and divergence trades.
Both strategies will require extensive backtesting with historical stock data sets such as those of FirstRate Data .
In contrast, divergence trades seek to profit from the anticipated divergence in price between two stocks. These trades are based on the trader’s belief that one stock will outperform or underperform the other due to company-specific factors or broader market trends. Divergence trades can be executed on stocks within the same industry or across different sectors.
Mean Reversion Trades
Mean reversion trades capitalize on the tendency of highly correlated stocks to revert to their long-term historical price relationships. Traders employ statistical regression techniques to identify stocks that exhibit strong correlations and have historically reverted to their mean price spread. These trades are often executed on stocks with similar business models or that operate in a similar industry.
A key advantage of spread trading is market-neutrality. Since the strategy profits from the relative price movements between the two stocks, it is not directly affected by the overall direction of the market. This characteristic makes spread trading a valuable trading strategy during periods of market volatility when the directionality is unclear.
Although spread trading has many advantages, it has some complexities and implementing the strategy requires careful consideration of several factors.
The Short Leg:
For non-institutional investors, the short leg of a spread trade can pose a challenge. Not all brokerages provide stock borrowing facilities to individual investors, limiting their ability to directly short a stock. Fortunately, alternative methods exist to execute the short leg.
Short-ETFs offer a convenient solution for implementing the short leg. These ETFs provide inverse exposure to a specific sector or index, allowing traders to mimic a short position without the complexities of borrowing stock.
Alternatively, traders can utilize put options to create a synthetic short position. By purchasing a long-dated in-the-money put option on the stock to be shorted, traders gain exposure to potential declines in the stock’s price.
Cost Considerations and Risk Management
Spread trades have several inherent costs and risk management challenges.
Accounting for Shorting Costs
Shorting a stock or utilizing short-ETFs incurs a stock borrowing fee, which can vary significantly depending on the stock or sector. These fees must be factored into the trade’s return expectations.
Put options, when used to create a synthetic short position, gradually lose value over time due to time decay. This erosion of value adds to the overall cost of the trade.
The correlations between the two stocks in a spread trade can change over time, invalidating the original trading thesis. Traders must regularly monitor these correlations to ensure the trade remains viable.