Be it football or chess, love or war, we rely on strategies to better enable us to win. Spread trading is no different, and this chapter will introduce you to some of the basic winning strategies.
But the first strategy in spread trading is to know what you are doing by undertaking a lot of good research. Unless you’re an expert in the market, or of a particular company or commodity, you don’t know all you need to know to decide what direction a trade will go, at what price to sell or buy at, how long to hold on to it, etc. Unless you decide to go just on a tip from a guy at a bar (which isn’t recommended), you need to put in your time doing your homework.
What to look for when doing your research
There are two main types of research known as Fundamental Analysis and Technical Analysis. Each has many areas to look at before making a call on a trade. Traders can spend years perfecting this trading research and analysis. Here we list a few of the main points to look at. Once you grow in your trading skills there are plenty of books, tools and courses available to further your knowledge.
What is Fundamental Analysis?
Fundamental Analysis is a method of evaluating a share by trying to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the share’s value, like the overall economy, industry conditions and individually specific factors like the financial condition and management of companies.
Michael Hewson, market analyst at CMC Markets says that one should also check such things as whether a company has exposure to commodity prices or the emerging markets. In addition, what kind of global reach does it have, where does it do its business, is it subject to geopolitical risk, what is its valuation like? The end goal of performing fundamental analysis is to produce a value that a trader can compare with the share’s current price in hopes of figuring out what sort of position to take with that share (underpriced = buy or long, overpriced = sell or short or don’t trade).
This method of analysis is considered to be the opposite of Technical Analysis (covered below).
Below is a list of factors that could be taken into account for Fundamental Analysis.
- Capital worth in Millions
- Projected Price/Earnings
- Price to earnings generated
- Most recent operational margin
- Most recent earnings per share
- Forecast on earnings per share
- Most recent profit
- Most recent net current assets
- Most recent interest cover
- Most recent net gearing
- Broker consensus
- Sector performance to index
What to look for in shares:
Potential for growth: Shares move up in price when the company’s earnings grow. Likewise, if you think the business is going to get worse and the earnings are going to slow, you would want to make a spread trade to sell the share.
Once you’ve done your research to see if a company has potential for growth, you have to make sure it’s still at a good value. Likewise, a stock that is doing poorly might already have that bad performance priced in. Take for example the financial crisis of 2008. If you had made a spread trade to sell the major banks before the market started to tumble, you would have made a lot of money. But by the end of the year, the prices had fallen so much that the share prices of financial institutions reflected that poor performance, thus they dropped in price. Still, though, at the low prices, you might take the view that they’ve factored in too much bad news into the price and that the banks would start doing better and thus the price would go up.
All of this can be analyzed by using two very important tools, the Price to Earnings ratio (P/E) and a company’s Earnings Per Share (EPS).
The P/E ratio shows the value of the price of a share, based on the company’s earnings. A company’s EPS is how much a company earns in a year for every share of stock. The P/E ratio equals the price of the share divided by its EPS.
P/E ratios are very relative, and you have to compare apples to apples, and not apples to oranges. Tech stocks, for instance, like Google and Apple, are going to have high P/E ratios, because they are really growing, and the price reflects that. A slow growth company, like an electricity company, will have a much lower P/E ratio because the price reflects that the business isn’t going to grow as much as a tech stock, for example. So if Google has a P/E ratio of 25 and XYZ Electrical Company has a P/E ratio of just 9, that doesn’t mean that XYZ Electric is better than Google, because you’re comparing apples to oranges. A growth company is going to be “more expensive” (a higher P/E) because you should hopefully be rewarded for all that growth. Or, if you think the P/E is too high, and the stock is too expensive for the growth that will come, you should execute a spread trade to sell the stock.
Other Tools and Strategies
1) Keep an eye on the news:
Keep an eye and an ear on the financial news. A big slowdown in the economy means people have less money, which means Apple will probably sell fewer Ipods. If a report like the number of new housing starts was down last month compared to a year ago, you might want to do a spread trade sell of home construction companies like Bovis Homes. These all affect a company’s expected sales figures, which is a key to stock performance, especially for retail and tech companies. Another news item to look out for is whether a key executive, like the company’s director, just sold or bought a lot more shares. While they may be basing their decision on more personal matters than the company’s fundamentals, perhaps they personally need to raise some cash for their family, for example, it’s usually a very good sign if an executive is buying, and if they are selling, it might be an indicator for you to sell that company as well. However it is only an indicator and should be backed up by other indicators from other sources.
2) The Net Asset Value (NAV) per share
A company’s NAV equals the company’s total assets (the value of everything it owns) minus its liabilities (everything that it owes). The “NAV per share” is a company’s NAV divided by how many shares it has outstanding. Financial websites will provide you with this information. And what do you do with the NAV? It’s a good way to find out a minimum price you would pay for a stock, because the NAV is a true measure of how much a company’s basic worth is, without factoring in future growth. You might want to look at companies whose share price is trading below the stock’s NAV per share. Why? Because even if the company fails, it’s still worth more when it needs to liquidate itself than the price you paid for it. You hope that the price will creep back up to the stock’s NAV per share and higher.
Note: For mutual funds, the NAV is the price per share of that mutual fund, or rather it’s value. Use it just like as if were a share’s price.
3) Earning estimates
For most major companies, a whole bunch of brokerages and analytical sites will tell you what they think a company will earn for the next quarter or year (their earning estimate). If the majority of estimates you read are estimating higher earnings, that’s a good sign to buy. Likewise, if the estimates are for less earnings then the same period a year ago, you should consider selling. But let’s say you buy a stock based on a consensus of good earning estimates, and the company ends up reporting earnings are lower than the estimates. You’re in for a drop in the share price.
One way to play earning estimates is to see if a trusted broker or information site estimates a company’s earnings to be higher or lower than the overall consensus of other sites and brokers. If you trust that information, researching how they come up with their estimate and your site estimates higher earnings than the consensus, that’s a good buying opportunity. Likewise, if your trusted site is estimating lower earnings than the consensus, that could be a good share to sell.
What is Technical Analysis?
Technical analysis is a share analysis technique that claims the ability to forecast the future direction of prices purely through the study of past and historical market data, primarily price and volume. In its purest form, technical analysis considers only the actual price and volume behavior of the market or instrument and “disregards” the actual nature of the company, market, currency or commodity which are focused on in Fundamental Analysis. Technical Analysis is based solely on “the charts,” that is to say price and volume information (what does the price chart look like?), whereas fundamental analysis looks at the actual facts of the company, market, currency or commodity. w
Here is a list of the main Technical Analysis indicators -:
Studying a share or commodity’s price chart over a certain period of time can give you good information on what direction the stock is trending, and perhaps more important, at what price you should buy or sell before it starts trending the other way. The idea behind chart analysis is that prices often follow a pattern over time. There are many forms of Chart analysis which can be learned fairly quickly.
Technical or Fundamental Analysis? Which type of analysis do you pay more attention to? Are you a Technical guy who prefers to rely on current financial data in chart form. Or, are you of the many out there who rely on company information, the company financial worth, market share and news etc. All have their pro’s and con’s – do you rely just on one, or a combination of them both?
Fundamental and Technical Analysis are often seen as opposites; some traders prefer to use one or the other for their research however most large trading houses and successful traders employ both Fundamental and Technical Analysis when researching potential trades.
As an individual trader there are a number of sources and software available to you which provide the relevant data for you to carry out your research. I have listed some of the main ones below to get your started.
The strategies and tools listed in this chapter will enable you to make good, insightful decisions on placing spread trades that will make you a lot of money. But in order for these tools and strategies to work for you, you must do your homework and research the stock or commodity.
We will discuss some more strategies in the next section.
Major Market Data and News Sources
Award winning trading and investment Software for UK, NYSE, NASDAQ, world indices and FOREX.
A leading provider of real‐time financial and market information.
Bloomberg.com is among the top five most‐trafficked financial sites on the Web. It is regarded as a premier site for news and financial information.
CNN.com delivers the latest breaking news and information on the latest top stories.
The latest European and international business, finance, economic and political news, comment and analysis from the Financial Times on FT.com.
The BBC is a major news media organization headquartered in London covering breaking news worldwide. Share prices and charts can be found on the website.