Spread Trading Explained: Understanding the Basics

Spread trading is a trading method that is highly appreciated by experts. It is a technique whose mechanism is surprisingly simple, but it is truly difficult to adopt. In fact, it requires a considerable amount of skills, which can only come from experience and in-depth study. What is meant by spread trading? Why is it considered a profitable method? The term "spread", translatable as "differential", suggests something about how it works. More can be inferred if we consider the other name by which it is known: "pair trading". The concept of "pairs" is central to spread trading. Those who trade with this technique, in a nutshell, take a long position on one asset and a short position on another asset that shares the same direction as the first. Generally, the asset chosen for the short position is slightly weaker than the one chosen for the long position. Therefore, one invests "in pairs". The reason is somewhat intuitive and twofold. On one hand, it maximizes profits. The aim is to capitalize on the differential between the two assets. This explains why, within the pair, one asset must be stronger than the other. The other reason stems from a defensive need. It is obvious: in case the trade fails, and therefore the pair, despite what was hoped for, depreciates, the asset positioned in the short position somehow protects the trader, limiting losses.

Spread trading strategy: the difficulties

Practicing spread trading is not easy. As already mentioned, it requires a lot of skills. It is necessary to study and analyze the market in depth. Not only to understand - as all traders are required to do - the direction that prices will take, but also and above all to identify the pairs. The study must take on a historical dimension since only from the past is it possible to draw evidence of relationships. If two assets are linked to each other, they have moved in the same direction in the past. Of course, in some cases, it is a matter of common sense. It is clear that the shares of an insurance company behave like the shares of a large automotive company. In any case, assets belonging to the same sector are preferred. Another element of difficulty is the presence of a certain predictability. The pairs, although logically and analytically correlated, could manifest a strong inhomogeneity within them due to exogenous events. These include scandals, legal problems, etc. In this case, the asset will not behave like its "companion", nullifying the spread trader's analysis work.