Stocks & Commodities V. 28:2 (64): Q&A by Don Bright

Q&A by Don Bright

SHORTING A SPREAD/PAIR

Don, could you explain what it means to short a spread/pair? If a spread X-Y (where X is the long position and Y is the short position) is determined to be overbought and due for a pullback, the spread could be “shorted” by selling X and buying Y. To me this means that you reduce the number of shares of X (sell) and you buy to cover Y (since you are short). If you do this, then one action would cancel the other out, so what would be the benefit? How should this be done properly? Thanks. —dvaneyl5

To short a spread pair is just a definition. If I short a $32 stock and buy a $30, I have effectively shorted the spread pair for $2.00. Some consider it as buying for a ($2.00) — depends on whether you’re an old option spread trader like me. Obviously, if you buy the $32 stock and short the $30 stock, you have “bought” the spread.

Now let’s get back to the basics of spread/pairs trading. We track hundreds of correlated pairs on a daily basis. We keep track of many variables, one of the most important of which is the six-month trading range. For example, let’s use that $32/$30 pair of X and Y. Now, by using a simple six-month price graph, we see that the pair has crossed the $2.00 line several times. It has a high differential of $6.00 and a low differential of $1.00 during this time frame. We look at all the fundamentals as well. We tend to run various time frames, determining how much the spread moves on a daily basis (so we know how much to expect from our intraday/intraweek trades).