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The majority of trading skills that are learned in one asset class can often be applied in another. In the Professional Futures Trader Course at Online Trading Academy, we teach students the skill of spread trading. Spread trading reduces the risk in trading securities and also takes advantage of mispricing between two related securities.
Spreads in futures, options, and also stocks involve buying one security while at the same time shorting another. Since you are both long and short, the overall movement of the market doesn't matter. There is no directional risk. If the market moves upward, both securities move up. The long will profit while the short loses. If the market drops and the prices of the securities drop, then the short profits while the long loses.
So how does one make money in these spreads? Well the pace that one security will move should be faster than another. If you pick the correct direction for the spread you make profits.
In the equity markets, this style of trading is called pairs trading. There are many publicly traded companies that do similar type of work or produce similar products. It makes sense that their stock prices should also move in similar manners. When one stock's price moves faster or slower than their related company's stock, then there is an opportunity to profit on the mispricing between the two.
You first need to select a pair of stocks (hence the name pairs trading) that are related. Their chart movement and correlation should be high. In the following example I used Exxon Mobil (NYSE:XOM) and Chevron Corporation (NYSE:CVX).
In the last six months, CVX and XOM have moved together approximately 87% of the time. This is most of the time but not ALL of the time. Prices are mean reverting. When the relationship between one stock's price and another changes due to one of them becoming overbought or oversold, you can use a pairs trade to profit as the prices return to their normal relationship, (mean reverting).
In the following example I have charted the price difference between CVX and XOM under the charts of the two stocks. On October 15th, XOM had become overbought (expensive), versus CVX. This caused the spread (price of CVX minus XOM) to narrow.
A pairs trader would have noticed the opportunity as the spread chart was also coming into demand and could have bought the oversold CVX at $108.57 and shorted the overbought XOM at $89.00.
Notice that the price of both securities moved upward. Your long would have made money while the short would have lost. The success in this trade relies on the spread between the two stocks widening. This happened when CVX moved up faster than XOM. By October 29th, the spread widened and hit a supply zone and the trader could have exited at the close of that day. The XOM position was shorted at $89.00 and closed at $94.59 for a $5.59 loss. The CVX long made $8.57 for a total of $2.98 profit on the spread. Both stocks moved higher but with the spread widening the trade profited. Even if both stocks moved down it could have been a profitable trade as long as the spread widened.
Before you go out and start jumping into pairs trades on related stocks, I must warn you that there is more to it. This was a simple spread because the two stocks had a similar Beta and also price point. In pairs trading, you want to be dollar and or market neutral. That is a little trickier and will be the topic of a follow up article. Until then, trade safe and trade well.
The original article can be viewed here