|What are spread trades, how do they work, and how can we use them?|
|Written by Administrator|
|Saturday, 24 October 2009 06:10|
by L.A. Little
The spread trading strategy receives too little attention even though a well-designed spread can offer excellent profit potential while decreasing risk. Spread trading isn’t viewed to be as glamorous as directional trades, so at the risk of turning you off I am going to turn your attention to what spread trades are and how they work; when they make sense; and how to implement them. Finally, I will show you a concrete example of how spread trades work in an actual trade.
|Holding||% of Total Portfolio|
|Wal-Mart Stores Inc||21.95|
|Home Depot Inc.||12.1|
|Lowes Companies Inc||7.19|
|CVS Caremark Corp||5.76|
|Costco Wholesale Corp||4.78|
|Best Buy Co Inc||4.09|
Ideally, it would be better if the percentage were not so high, but then again few trades are perfect. The risk versus the reward is what is critical, and that critical part of the equation is favorable, as discussed next.
Turning your attention to the charts, you’ll note that RTH has managed to move higher despite decreasing volume, which eventually becomes a problem. Higher prices not accompanied by higher volume will eventually succumb to selling pressure. As can be seen in the chart of RTH, current volume compared with volume when prices were falling a year ago is at absurd levels. This suggests that prices for the broader index are more likely to decrease over the near term rather than increase.
Now compare the volume in WMT as a result of their earnings announcement. Volume surged on the increase in price: a stark contrast to what was witnessed in RTH. Although volume is not above the levels seen when intense selling hit a year ago, there certainly is no comparison between RTH and WMT with respect to this factor.
Additional factors are that WMT is at a much lower price level relative to RTH and on a short-term basis has solid support around the $50 level and should be able to reach the $54 level. RTH, on the other hand, is more likely to pull back to the $82 level before moving much higher at all.
In the worst case, if RTH pulls back to the $80 level, it is about a 6% drop in price. WMT back down to $50 would represent a 4.7% reduction. On the flip side, if prices continued to rise, WMT would also outgain RTH as it clearly shows distribution in its chart, while WMT shows accumulation.
The real measure of the trade can be more easily seen when you overlay WMT and RTH as shown in the Figure below.
Here we can see that in the past two trading days, WMT has gained 5% while RTH just 3.5%. What’s more important is that WMT has greatly underperformed and the spread between WMT and RTH is near the highs for the past year. A 50% reduction in the spread between these two instruments could represent a 5% gain on the spread trade.
The risk is that the spread widens again. You should determine how much you are willing to let the spread widen prior to entering the trade and use that spread percentage as your stop-loss target. In this example, the spread should not widen too much more than it was prior to WMT’s earnings surprise, or a 14% spread differential.
A paired spread trade can offer ideal opportunities for the astute trader. When times are more volatile than usual and a trader is forced to trade smaller on unidirectional trades, a paired trade offers the opportunity to put more money to work and do so with less risk. An astute trade can capture profits with less risk in such an environment by examining relationships between individual stocks and the sector ETFs that they trade in. Earnings announcements offer ample opportunities when viewed in this light.
L.A. Little is an author, professional trader, and money manager who writes daily on www.tatoday.com. His new book,
Trade Like The Little Guy, shows small traders how they can consistently profit in the markets.
‡Prophet Financial Systems
‡See Editorial Resource Index
Originally published in the November 2009 issue of
Technical Analysis of Stocks & Commodities magazine.
All rights reserved. © Copyright 2009, Technical Analysis, Inc.
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