Spread trading is more an art than a science, but there are a few common traps we often see new traders fall into.
1. Bad Timing.
A spread should not be used to cover up a bad trade.
Consider this scenario: Trader Ted gets long the Tbond at 142-26 after what he sees as a decent rally and one he expects will continue (exhibit A).
The market then falls away, down to 142-00 before Ted decides to act. Rather than stopping out the trade and admitting the trade was simply a bad one, Ted sells some 10yr notes against it, thinking he will “spread it off” and watch it come back (exhibit B).
Think about the logic here. Ted is 26/32nds offside and then enters into a position that will require the bonds to rally well beyond his original buy price just for that spread to make a decent advance. Pure logic suggests he has a far better chance of simply holding the outright bonds in anticipation of a bounce.
Admittedly the trade would reduce the downside if the market kept falling, but it virtually gives away any chance of making back the ticks already lost.
As a rough estimate, the bond would have to rally by twice as much as the fall for that spread to make back the lost ticks.
Turning an outright losing trade into a spread is not a spread strategy.
Admittedly the example above shows a trade that was off side by a large amount before spreading. However the exactly the same logic applies to smaller moves. Spreading something off makes it harder for you to make money.
2. Bad Correlations
A spread involves opposing positions in correlated markets and the same positions in inversely correlated markets.
Most of the time, stocks and bonds are inversely correlated. It is not unprecedented for a trader to spread these markets, perhaps trading relative values or extremes in one versus another.
So what does a spread in say the S&P versus the Tnote look like? Are you long one and short the other? If you think about it, that is a double directional trade. If they are inversely correlated (stocks go up bonds go down), then being long one and short the other is taking an even bigger directional position that you would be trading just one of the markets outright.
The correct spread trade to make in inversely correlated markets is to be long both or short both. That is a spread.
3. Bad Ratios
If we look at the Aussie 3s:10s spread as being a 3:1 ratio, then are you spreading when you are long 30 threes and short 30 tens?
The answer is yes and no. One way to look at it is you have a spread of 30 threes and 10 tens PLUS another 20 tens. You are essentially overweight in one leg of the trade and therefore adding a directional bias.
There is nothing wrong with doing this if it fits into your view, but it’s not a simple spread trade in the strict definition. Placing these trades requires a directional view as well as a relative value or spread view. In many cases you may simply be better off placing a smaller directional trade.
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