A spread trading strategy is important as it gives you guidelines and metrics to trade by, making sure to avoid impulsive trading or letting your emotions interfere with your trading. There are a lot of different spread trading strategies, perhaps as many as there are spread betters, but many of them contain the same basic principles. A trading strategy goes hand in hand with having a risk management plan. One strategy employed by every successful spread better is to cut losses rapidly before they mount up, and usually this is done by setting stop loss orders when taking out the initial bet. Unfortunately, a common mistake that beginners tend to make over and over again is to enter trades without having a clearly defined profit or loss strategy.
A truth about any financial trading is that the market is bigger than you are, and it will do what it wants, regardless of what you think it should do. You need to react to what the market is doing rather than bemoaning that it didn’t follow your plan. So make sure that you don’t sit on a losing position until it becomes irrecoverable. Also, strategies will work until they stop working meaning that the same strategy won’t work in all market conditions. If we look at the dot com boom for instance, many traders with trading systems thought that they have unlocked the principles of trading simply because all it took to make money at the time was to open long positions. We all know what happened after…
One particular technique you can use is called pairs trading. This is based on the relative value of two different financial securities, such as shares in two companies. While you may be unable to anticipate the ebb and flow of a market sector, you can often tell when two companies in that sector which normally go up and down together get out of sync.
Take for example two healthcare companies. Healthcare as a sector is generally growing as the average age of the population increases, but sometimes there are setbacks such as government regulation that affect all healthcare companies similarly. However, if you identified two major healthcare companies where one had increased in price and the other hadn’t, you could execute a pairs trade that shorted or sold the high-priced shares and bought the lower-priced.
The reason for this is you expect the normal relationship between the two companies to re-establish itself, and by trading in pairs you are protected from the sector going up or down as a whole.
Another strategy is called arbitrage, which involves identifying differences between offerings on the same product. You may have come across this term with eBay, where some users would find products which were selling for less than their usual value, perhaps because of a misspelling in the listing or a wrong category choice, and straight away list them for sale, selling at a higher price, sometimes without even having to handle the products.
With spread betting arbitrage does not happen often, but it guarantees a profit if you can find it. Arbitrage happens when one spread betting provider takes a different view of a particular market than another broker. The spreads and the prices are based on the provider’s knowledge and experience of the market, and sometimes these interpretations can vary between brokerages.
To take advantage of arbitrage, you need to compare the offerings between the different providers. It is seldom that there is a dramatic difference, and that is why spread betting arbitrage is a rare opportunity. What you’re looking for is spread betting quotes for the same underlying financial security where the spreads do not overlap. For instance, if one broker quoted 52 — 54, and another 55 — 58, then you could buy at 54 from the first broker and sell at 55 with the second, guaranteeing a profit. This is one of the few spread trading strategies which is absolutely sure to succeed.
Some spread betters also make use of the dividend stripping strategy. When you hold a long spread betting position on ex-dividend day, you will receive dividends for that spread trading position in a similar way as if you held the physical shares. Thus when using leverage to buy more of the underlying stock investment using margin you also magnify dividend payments as well as price swings for the stock. Note that if you are holding a short spread trading position, you will be obliged to pay dividends on your position.
Here’s an example of rules from a system-based trading strategy:
Lets establish some rules:
- We are not in the business of predicting, only following the market.
- We do not want you to enter at the exact bottom, and we do not want you to exit at the exact top.
- We will identify only the change of short term trends within the major trend, and enter or exit at these changes.
- If the main trend is up, and the short term trend changes from down to up, then we will buy into the market. Go Long.
- When the main trend is up, and the short term trend changes from up to down, then we will exit the market by selling our buy. Close Long.
- Conversely, when the main trend is down, and the short term trend changes from up to down, then we will sell the market. Go Short.
- When the main trend is down, and the short term trend changes from down to up, then we will buy back our shorts. Close Short.
- We will always keep our trades protected with stop losses.
- Trading with stop losses is like driving a car using a seat belt. It does not cost anything, but it can save your life in adverse circumstances.
In our trading guide we examine some of these trading strategies in more detail – approaches and trading systems that you can put into practise straightaway using spread betting, and at a level of risk that suits your own particular circumstances.
“Simple spread trading strategies work just as well as complicated ones. This is because it isn’t so much the strategy that wins the money but the small losses and big wins – simple as that… Keep your trading and overall strategy as simple as possible. Also, trade small as a percentage of your overall account. I wouldn’t recommend anything more than 2% risk per trade.”