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martes, 4 de octubre de 2016

Investment Strategies: Spread Trading

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Investing in pairs or spread trading is relatively common in the world of institutional investors, but rare among minor investors, mainly because one of the two legs of the strategy involves a short position. This fact can limit access to retail investors, because they tend to have more difficulty finding a broker that allows them to open a short position on an asset.

In general terms, spread trading is to bet that an asset will perform better than another, regardless of whether the market rises or falls. That is, it is considered a market neutral strategy, because if our forecast is met, it does not matter what the market do.

What is spread trading?

This strategy can be done with indexes, commodities, stocks, etc. If currencies come into play, we must take into account the exchange rate to predict the gain or loss.  An example: if we believe that Telefonica will have a better performance than Vodafone, it may be that in their local currency this might happen (Telefonica rise more in euros than Vodafone in pounds), but by making the conversion with the exchange rate, the effect can be the contrary. 

The benefit can be generated with any of the two legs, both short and long position. That is, we can win because our long position moves higher (or lower less) than the short position (or vice versa, of course).

How this strategy is applied? 

The first thing to do is pick the two assests that we are going to compare and oppose. At that moment we set the ratio between the two to equal weights in our portfolio. 

For example, if we believe that stock A will have a better performance than stock B and these shares are quoted at 2 and 4 dollars respectively, we apply a ratio of  2 to 1. If we want to invest $10,000 in a pairs trade with these stocks, then we would have to buy 2,500 shares of stock A and sell 1,250 shares of stock B.

Regular products to apply spread trading strategies

As we have seen, we need products that allow us to trade in favor and against an asset. We can do it through CFD's and Futures or directly with shares. Without going any further, many brokers offers the possibility to open short positions in shares and other popular products, including futures on stock market indices.

Advantages and disadvantages of spread trading 

  • The main advantage is that we can make a profit if we succeed in choosing good assets on which we will focus, no matter how the rest of the market behaves. 
  • One drawback is that in some assets used regularly to make spread trades we have to use leveraged products. In the case of CFD's we have a daily cost, while in the case of future we must provide guarantees.
  • If we choose to short sell shares through securities lending, we have to remunerate who lends us these securities.
  • Both the CFD financing costs as the cost of securities lending will be lower the shorter the duration of the operation, because we only pay interests for the days in which the positions remain open.

Practical example of spread trading 

If we go back to the previous example of Stock A and Stock B, we will see the results of operations in various scenarios to see what we can win/lose depending on the market behaviour. We must clarify that transactions costs are not considered, which would reduce the profit or increase the losses.

Case 1: The stock market rises and we win 

 Starting Position:         

  • Long 2,500 shares of Stock A at $2/share: $5000
  • Short 1,250 shares of Stock B at $4/share: $5000
  • Total: $10000 
Closed position:              
  • Long 2,500 shares of Stock A at $2.5/share: $6250
  • Short 1,250 shares of Stock B at $4.25/share: $4687.5
  • Total: $10937.5
Both shares have risen, but as Stock A has risen more (25% vs  6.25%), we make money.

Case 2: The stock market rises and we lose 

 Starting Position:         

  • Long 2,500 shares of Stock A at $2/share: $5000
  • Short 1,250 shares of Stock B at $4/share: $5000
  • Total: $10000 
Closed position:              
  • Long 2,500 shares of Stock A at $2.5/share: $6250
  • Short 1,250 shares of Stock B at $6/share: $2500
  • Total: $8750
Both shares have risen, but as Stock A has risen less (25% vs 50%), we lose money.

Case 3: The stock market goes down and we win

 Starting Position:         

  • Long 2,500 shares of Stock A at $2/share: $5000
  • Short 1,250 shares of Stock B at $4/share: $5000
  • Total: $10000 
Closed position:              
  • Long 2,500 shares of Stock A at $1.5/share: $3750
  • Short 1,250 shares of Stock B at $2/share: $7500
  • Total: $11250
Both stocks are down, but as Stock A dropped less (25% vs 50%), we make money.

Case 4: The stock market goes down and we win

 Starting Position:         

  • Long 2,500 shares of Stock A at $2/share: $5000
  • Short 1,250 shares of Stock B at $4/share: $5000
  • Total: $10000 
Closed position:              
  • Long 2,500 shares of Stock A at $1/share: $2500
  • Short 1,250 shares of Stock B at $3/share: $6250
  • Total: $8750
Both stocks are down, but as Stock A dropped more (50% vs 25%), we lose money.

Conclusion 

As we have seen in the examples, with this strategy we only have to worry about choosing the right assets. From there, it will not matter to us if there is a Brexit or if the Fed interest rate varies. As we have seen, we can trade with multiple shares, CFD's, futures or currencies, setting the numbers always to have the same risk for both the sell leg and the buyer leg.

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