Spread Trading Strategy (Backtest – Does It Work?)
Last Updated on April 18, 2023
A popular trading strategy, spread trading is one trading method every beginner in the financial market should get to know. It is arguably the most straightforward method of speculating on financial markets and may be suitable for new traders who don’t yet know how to navigate complex strategies. Want to know about spread trading?
Also known as relative value trading, spread trading is the simultaneous buying and selling of related securities as a unit, designed to profit from the price difference (spread) between the two securities. The aim is to generate profit when the spread widens or narrows. Spread trading can be used for both short-term and long-term trading, and it is commonly used by professional traders and portfolio managers as a way to manage risk and enhance returns.
In this post, we answer some questions about spread trading, and at the end of the article we make a backtest.
What is Spread Trading?
Also known as relative value trading, spread trading is a type of trading strategy that involves buying and selling two related financial instruments at the same time, with the goal of profiting from the difference in price (the spread) between the two.
One common example of spread trading is buying a stock and selling a call option on that stock at the same time. This creates a “spread” between the price of the stock and the price of the option, and the trader’s goal is to profit from changes in that spread. Spread trading can be done with a variety of different financial instruments, including stocks, options, futures, and currencies.
Spread trading can be used for both short-term and long-term trading, and it is commonly used by professional traders and portfolio managers as a way to manage risk and enhance returns. The strategy is considered a limited risk strategy as the potential loss is limited to the difference between the two legs (the security being sold and the one being bought) of the spread.
However, it can be complex and difficult to execute properly, and it may not be suitable for all investors. It is important to understand the underlying market conditions and the financial instruments being used before attempting to engage in spread trading.
What are the Benefits of Spread Trading?
There are several benefits to spread trading:
- Risk management: Spread trading can help manage risk by offsetting the potential loss on one leg of the trade with the potential gain on the other leg.
- Enhanced returns: Spread trading can help increase returns by taking advantage of small price movements in the market.
- Diversification: Spread trading offers the diversification benefit, as you are investing in multiple financial instruments at the same time.
- Reduced volatility: Spread trading can help reduce volatility by offsetting the potential loss on one leg of the trade with the potential gain on the other leg, which can make it a more stable strategy for investors.
- Market neutral: Spread trading can be done in a market-neutral way, which means it can be done without taking a directional view of the market.
- Leverage: Spread trading can be used to leverage a small amount of capital to generate large profits.
However, you should note that, as with any investment strategy, spread trading also carries some risks, and it’s important to understand the underlying market conditions and the financial instruments being used before attempting to engage in spread trading.
What are the Different Types of Spreads?
There are several types of spreads, depending on the asset class involved. These are the common ones:
- Calendar spreads: This involves buying and selling options with different expiration dates.
- Inter-commodity spreads: Involves buying and selling two different commodities, such as crush spread (soybeans and soybean meal or oil) and crack spread (crude oil and gasoline).
- Intra-commodity spreads: Involves buying and selling different futures contracts of the same commodity, such as buying December corn and selling March corn.
- Inter-market spreads: This involves buying and selling related markets, such as buying a stock index and selling a bond index.
- Option spreads: Involves buying and selling options on the same underlying asset, such as buying a call option and selling a put option. Examples include credit spreads, debit spreads, bull spreads, and bear spreads.
What is the Best Spread Trading Strategy?
The best spread trading strategy depends on the individual trader’s goals, risk tolerance, and market conditions. Some of the commonly used spread trading strategies include:
- Trending market spread betting strategies: They involve taking advantage of market trends to generate profits. Position trading can make use of this approach
- Consolidating market spread betting strategies: They involve profiting from a market that is not trending in a clear direction, but instead, “consolidating” or moving in a narrow range.
- Breakout spread betting strategies: When using these strategies, your plan is to identify key levels of support and resistance in the market and then place trades when the market breaks through those levels.
- Reversal spread betting strategies: For this, you are looking for turning points in the market and making trades in expectation of price reversals.
What is the Difference Between Spread Trading and Other Types of Trading?
Spread trading involves buying and selling two related financial instruments at the same time, with the goal of profiting from the difference in price between the two. Other types of trading typically involve buying or selling a specific type of financial instrument — for example, you can buy a stock to profit from capital appreciation or dividends.
Spread trading can be done with a variety of different financial instruments, including stocks, options, futures, and currencies. It is commonly used by professional traders and portfolio managers as a way to manage risk and enhance returns. Other types of trading are more commonly used by individual investors.
What Are the Risks of Spread Trading?
Some of the risks of spread trading include:
- Market risk: The risk that the market will move against your position, resulting in a loss.
- Liquidity risk: The risk that you may not be able to enter or exit a position at a favorable price due to a lack of liquidity in the market.
- Credit risk: The risk that a counterparty will default on a contract, resulting in a loss.
- Volatility risk: The risk that the value of a position will fluctuate due to changes in volatility in the market.
- Margin risk: The risk that a margin account will not have enough funds to meet the margin requirements of a trade.
- Interest rate risk: The risk that a change in interest rates will affect the value of a position.
- Leverage risk: The risk that leverage will amplify losses.
- Counterparty risk: The risk that the other party in a contract will not fulfill its obligations.
What Markets Are Good for Spread Trading?
Spread trading can be applied to a variety of financial markets, including stocks, options, futures, currencies, and commodities. However, some markets may be more suitable for spread trading than others depending on a variety of factors such as liquidity, volatility, and margin requirements. Futures and options markets are often used for spread trading and typically involve commodity futures, interest rates, stock indices, calendar spreads, and so on.
What are the Most Common Spread Trading Strategies?
There are many spread trading strategies that can be used, but some of the most common include:
- Calendar spreads strategy — buying and selling options with different expiration dates.
- Inter-commodity spreads strategy — buying and selling two different commodities, such as buying wheat and selling corn.
- Intra-commodity spreads strategy — buying and selling different futures contracts of the same commodity, such as buying December corn and selling March corn.
- Inter-market spreads strategy — buying and selling related markets, such as buying a stock index and selling a bond index.
- Option spreads strategy — buying and selling options on the same underlying asset, such as buying a call option and selling a put option.
- Bull Spreads strategy — buying an option with a lower strike price and selling an option with a higher strike price, in anticipation of the underlying asset increasing in price.
- Bear Spreads strategy — buying an option with a higher strike price and selling an option with a lower strike price, in anticipation of the underlying asset decreasing in price.
- Credit Spreads strategy — buying an option with a lower strike price and selling an option with a higher strike price.
- Debit Spreads strategy — buying an option with a higher strike price and selling an option with a lower strike price.
How to Choose the Right Spread Trading Broker
Choosing the right spread trading broker is an important decision that can have a significant impact on the success of your spread trading strategy. Here are some factors to consider when choosing a spread trading broker:
- Regulation: You should choose a broker that is regulated by a reputable regulatory body such as the FCA (Financial Conduct Authority) or the SEC (Securities and Exchange Commission).
- Platform: Choose a broker that offers a platform that is user-friendly, stable, and reliable.
- Market access: Be sure the broker offers access to the markets you want to trade in, whether it’s stocks, options, futures, currencies, or commodities.
- Execution speed: Choose a broker that offers fast and reliable execution of trades to minimize the risk of slippage.
- Customer support service: Look for a broker that offers excellent customer service, including support for questions and issues related to trading.
- Fees and costs: Compare the fees and costs associated with different brokers, such as spread costs, rollover fees, and overnight financing costs, to find the most cost-effective option.
- Research and analysis: Look for a broker that provides access to research and analysis tools such as market news, economic calendar, and technical analysis reports.
How to Manage Risk When Spread Trading
Managing risk is an important aspect of spread trading, as it helps to protect your capital and increase the chances of long-term success. Here are some ways to manage risk when spread trading:
- Use a stop-loss order
- Diversify your portfolio
- Understand the market and the financial instruments you are trading
- Use leverage cautiously
- Have a risk management plan
- Monitor your trades
- Use risk management tools
- Manage your emotions
What Are the Best Practices for Spread Trading?
Spread trading is a complex strategy that requires a lot of knowledge and experience. Here are some best practices for spread trading:
- Understand the underlying market conditions and the financial instruments being used
- Use a risk management plan
- Focus on liquidity and volatility
- Diversify your spread trading portfolio
- Watch out for the margin requirements
- Monitor the spread consistently
- Don’t overleverage
- Have discipline
- Have a trading plan
- Continuously learn and improve
What are the Advantages and Disadvantages of Spread Trading?
Spread trading comes with both advantages and disadvantages.
The advantages include:
- Limited risk
- An inherently diversified portfolio
- Market neutral position
- Improved returns
The disadvantages include:
- It may have large margin requirements
- Unduly affected by slippage
- Limited profits
- Too complex for the average investor
How to Get Started in Spread Trading?
Getting started in spread trading can be challenging, but you can do it if you know how. Here are some tips to get started in spread trading:
- Learn the basics
- Study the markets to choose the ones to trade
- Develop a trading plan that would guide your trading journey
- Choose a broker that is regulated, offers a good platform, and charges the best fees
- Practice with a demo account
- Start with a small amount you can afford to lose and grow gradually
- Keep records so you can evaluate the performance of your strategies and make adjustments as needed.
- Keep learning and improving
What Are the Tax Implications of Spread Trading?
The tax implications of spread trading can vary depending on the country and jurisdiction in which you reside and trade. In general, spread trading profits are considered to be capital gains and are subject to capital gains tax. However, the tax treatment of spread trading can also vary depending on the type of spread trade, the holding period, and other factors.
In the United States, for example, capital gains on spread trades held for less than one year are considered to be short-term capital gains and are taxed at the same rate as ordinary income. Capital gains on spread trades held for more than one year are considered to be long-term capital gains and are taxed at a lower rate.
In the United Kingdom, spread betting is tax-free for UK residents, as long as spread betting is not the individual’s sole source of income. It’s important to consult with a tax professional to understand the tax implications of spread trading in your specific jurisdiction and to ensure that you are properly reporting and paying taxes on your spread trading gains.
What Are the Different Spread Trading Platforms?
There are various spread trading platforms offered by various brokers or third-party agents, each with its own features and benefits. These are some of the popular ones:
- Interactive Brokers’ Trader Workstation
How Does Spread Trading Differ from Day Trading?
Spread trading and day trading are both investment strategies, but they have some key differences:
- Time horizon: Spread trading involves holding positions for a period of time, usually days or weeks, while day trading involves buying and selling within the same trading day.
- Risk profile: Spread trading usually involves a limited risk, as the potential loss is limited to the difference between the two legs of the spread, but day trading can be a higher-risk strategy.
- Market exposure: Spread trading can be market-neutral, while day trading is typically based on the expectation that the price of the financial instrument will move in a particular direction.
- Trading style: Spread trading is a passive trading strategy that waits for the market to come to it, whereas day trading is an active strategy that takes advantage of short-term market movements.
How Do You Analyze the Markets for Spread Trading?
Analyzing the markets is an important step in spread trading, as it helps to identify potential opportunities and manage risk. You can analyze the markets using technical and fundamental analysis methods, as well as volatility analysis. Other methods of analysis include the use of Options Greeks, seasonal analysis, spread charts, and correlation analysis.
It’s important to note that no single approach or tool can guarantee success in the markets. So, you may want to use a combination of different analysis methods to make informed decisions.
What Are the Different Types of Orders Used in Spread Trading?
A spread order is a combination of individual orders (legs) that work together to create a single trading strategy. Different types of orders that can be used in spread trading include:
- Market order
- Limit order
- Stop-loss order
- Stop-limit order
- Trailing stop-loss order
- Contingent order — requires a condition to be met before the order is executed
- OCO (One Cancels the Other) order — if one of the orders is executed, the other order is automatically canceled.
How Can Spread Trading be Automated?
Spread trading can be automated using trading software and algorithms. You may code the trading algo yourself or pay someone to do it for you. It’s important to note that automated spread trading carries the same risks as manual spread trading and it’s important to test and backtest the automated strategies before using them in real-time trading.
Spread Trading Strategy – Backtest – Does It Work?
A backtest with trading rules and settings is coming shortly.