This spread trading strategy is most commonly used for stocks and equities, as you can confirm the strength of the stock in relation to the market in general and the sector. To use this strategy, you look for a market that is going up, and a sector that is also going up. Now you want to pick a stock that is performing better than the market and the sector, and therefore showing its strength. You should look for a stock that has performed better than the sector by, say, 2% on each of the last four weeks.
When shares are going down in value, investors and traders are more prone to cut their losses and exit the markets while buyers are afraid to buy. Thus, when momentum is negative the buyers get spooked. On the other hand traders think, ‘Somebody must know something, so I should get out.’ The real question investors should be asking in such circumstances is what caused the original decline.
You may sense momentum building in a stock or commodity–going up or going down in price–where the action is like a snowball rolling down a mountain, getting bigger and bigger. This can happen to stocks and commodities, and it represents a great sign to get in (either buying or selling) as its starts its roll, so that you’re in it as it gets to be that giant snowball of profits.
You can tell something is gaining momentum by looking at the volume of shares being traded. Using a trading company with Level II information shows you the blocks of shares being bought with each order from someone. Let’s say you’re looking at Intel, with a spread of 12.25 – 12.50. If you see on your screen with the Level II data that there are a lot of people placing orders at the Ask, 12.50, much more than the bid of 12.25. This would be a good sign that you should buy Intel right then, like everybody else is doing, as the price should move up with momentum to the upside.
You take a long position with your spread bet, looking for the stock to continue rising because of its strength. Your initial stoploss position should be just below the lows of the previous few weeks, as if the price drops to these, the uptrend in the stock has failed. You can exit with a profit using a trailing stop, or you can follow the trends in the market and exit if the overall market or the sector reverses into a downtrend, or any time the stock is not outperforming the sector, as this would show individual weakness.