Spread trading is basically buying one product that is suppose to be related to another product so you hedge out the market risk.
Give you an example. Suppose you buy HSBC thinking that is a good company but you don't want market risk to affect your trade. So you short Barclays by the same amount. So in effect you are betting on HSBC will do better than Barclays and even if the market move up or down you'll be hedge from market risk and you pay extra commission and double the capital to make that trade and make a profit on their quality difference.
Now when it comes to products like bonds and oil for example there is little changing quality factors and in 'normal' market conditions there should be relatively little difference between the products and so they should move in synch with each other where the only difference is due to market inefficiency when one product suddenly move outta synch with the market. So say a big trader comes in and buy lots of Schatz and prices move too much for it. So the model to make money at Schneider is that you mean revert the spread and provide the liquidity to make the market more efficient. When the spread moves too much one direction due to whatever shocks, you bet the other way since they usually come back to the same price and those shocks were only temporary and you quickly take advantage of that.
But recently it just haven't been the case.. at least to day trade it. The spread don't mean revert on a daily basis and if it trends in one direction and you are betting it to go back to 'normal' then you'll get screwed. The problem is that you need to make money at least two days for every day you lose just to break even due to the commissions and can't even afford 50/50 win/lose. And right now it is about 50% trending days and 50% ranging days. In fact, recently it is probably something like 80% trending days.
Now I have been told this usually isn't the case since all the big traders are suppose to be away in August and so the market is more volatile then usual. But that is not helping me because I am paying desk fees to trade a product I have little edge in making money. If the spread don't mean revert, then there is little reason to play spreads. I am suppose to pay double the commissions for a less risky trade and make sure money in spread trading. Now I am just paying extra to play a risky product that would rinse me out if I try to mean revert it and have not a lot to go on how to make money on it.
I have been doing okay recently because I simply threw mean reversion out of the window and mainly using TA and price action. But if I were to trade using TA/price action, there is little reason for me to do spread trading. TA works way better just on a single product since there is lots of info out there on resistance and support levels as well as fundamental news that I can use. There is relatively little out there concerning the spread itself. One of the manager had a go at me the other day about not been at my desk when some important news came out and I thought to myself news don't matter anyway since it doesn't help me make money predicting the spread. You don't need to know anything about markets to spread trade which I thought was the reason they use spread trading model in the first place.
For example, imagine HSBC is considered to be a safer stock and Barclays is considered to be a riskier stock. If the stock market falls, HSBC tends to hold is value better than Barclays so the difference between the two you can predict how that spread moves if the stock market falls. But in trading the Euribor and Schatz so far.. it is just so unpredictable that you can v easily get rinsed if that relationship changes. I thought bonds would go up on Friday since I thought after Benanke speech the stock market will go down so I bought the spread to go up since when bonds rises, my spread goes up. Instead the spread fell when bonds went up and luckily the bonds came back down hard when the stock market reversed the fall and I was able to get out at a profit.
I think there is a way you can get to understand how your spread works over time but still it is very hit and miss for me right now. Some times I were able to take advantage of it to make money yet there are other times when it completely throw me off. How can you tell when and why Schatz move faster than Euribor? There isn't any news that can help you and only way is trying to find patterns from price action and hope TA holds up in the spread.
Another way to make money is by scalping or leggin in the market and using the spread to 'hedge' when you get your scalping wrong. I still haven't figured out the technique of doing it and right now mainly trying to concentrate on how to predict the movement of the spread. As a new trader, you are not even suppose to do that but really if you are just spread trading in this market, it'll be hard to make money since you are trading with bad odds. Playing an relatively unpredictable product that can go either way fast with a short stop limit. When the market is so volatile I pretty much get in my spread on the outrights that is moving in the right direction and hope to ride an extra half tick or tick to get a better spread. That has given me a few extra bit of profit that has help a bit in keeping my head above water.
If you have a look on this forum in the prop trading firms section I have written more there for more info. Have a look there.
