Spread charts are powerful visualization tools that compare the price of one financial instrument against another variable, such as a different asset, a numerical value, or a currency. They offer traders a unique perspective on relative value and are increasingly popular for their ability to help mitigate certain market risks. This guide will explain what they are, how to use them, and their most common applications.
What Is a Spread Chart?
A spread chart is a comparative graph that plots the relationship between a financial instrument and another variable. This relationship is defined by a mathematical operation: subtraction, addition, multiplication, or division. By creating these comparisons, traders can gain insights into correlations, relative strength, and arbitrage opportunities that are not visible when looking at assets in isolation.
The use of spread charts is versatile. Some of the most popular methods include price inversion, currency conversion, financial instrument comparison, and pair trading. These techniques allow analysts to formulate strategies based on the performance of one asset relative to another.
How to Create and Set Up a Spread Chart
Creating your own custom spread chart on most advanced platforms is a straightforward process. Here’s a step-by-step breakdown:
- In the symbol search window, input your first variable. This could be a ticker symbol (like AAPL for Apple Inc.) or a numerical value.
- Enter one of the four allowed operators: subtraction (-), addition (+), multiplication (*), or division (/), and then press the spacebar.
- In the same search window, input the second variable (e.g., another ticker symbol like XAUUSD for gold).
For instance, typing AAPL / XAUUSD would create a chart showing the price of Apple stock divided by the price of gold. This allows you to track how many ounces of gold one share of Apple can buy over time.
It's important to understand how the data is processed. For intraday charts, the spread is calculated by taking the OHLC (Open, High, Low, Close) values of each one-minute bar, which are then compiled into your selected timeframe. This server-side processing ensures accuracy in the resulting spread chart.
Note: A single spread chart can contain a maximum of 10 unique instruments.
Can a Spread Chart Repaint?
Yes, spread charts can repaint. This occurs because real-time bars are built from tick data, while historical bars are constructed from minute data. Historical data does not contain the sequence of tick-level price movements within each bar. Since the order of these ticks is crucial for building a real-time spread bar, discrepancies can arise between the live data and the historical data.
When you refresh your chart, you might notice that some bars change slightly. This behavior is important to remember if you set price alerts based on a spread chart, as the triggering condition might differ upon a refresh.
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Common Types of Spread Charts and Their Uses
Spread charts can be applied in numerous creative ways to uncover trading opportunities. Here are some of the most common types.
Chart Inversion
Inverting a chart is an excellent way to visually represent the correlation between two instruments. If two assets have a low or negative correlation, inverting one of them can make their price movements appear to align in the same direction, making the relationship easier to analyze.
- Example: To invert the EUR/USD currency pair, you would use the formula:
1 / EURUSD.
Currency Conversion
You can use multiplication or division to view the price of a commodity or stock denominated in a different currency. This is incredibly useful for international traders assessing value across markets.
- Example: To see the price of Best Buy (BBY) stock in Euros instead of U.S. Dollars, you would use:
BBY / EURUSD.
Instrument Comparison
A very common use of spreads is to divide one instrument by another. This allows you to track the ratio between them as a single, continuous data series, ideal for identifying long-term trends in relative performance.
- Example: To compare the performance of Apple stock (AAPL) against gold (XAU), you would create the spread:
AAPL / XAUUSD.
Exchange Arbitrage
Spread charts can highlight price discrepancies for the same asset trading on different exchanges. This arbitrage opportunity is visualized by subtracting the ticker from one exchange from the ticker on another.
- Example: To see the price difference for Meta stock (META) between the BATS and NASDAQ exchanges, you would use:
BATS:META - NASDAQ:META.
Crypto Arbitrage
With the rise of cryptocurrencies, bitcoin arbitrage has become a popular trading strategy. Spreads can help identify pricing differences across various crypto-fiat pairs or exchanges.
- Example: A complex cross-exchange arbitrage might look like:
BTCUSD - BTCEUR * EURUSD.
An Overview of Pair Trading
Pair trading is a classic strategy that involves simultaneously taking opposing positions in two different but correlated instruments to execute a single market-neutral trade. The core principle is to profit from the convergence of their relative prices while minimizing exposure to overall market direction.
How Pair Trading Works
The strategy begins by identifying two securities with a historically high correlation (or a strong negative correlation). Once the ratio of their prices deviates significantly from its historical mean—often measured by a certain number of standard deviations—a trader will go long the underperforming asset and short the outperforming asset.
The profit is realized when the relationship between the two prices reverts to its mean, at which point both positions are closed. Many technical analysts use the Bollinger Bands indicator to visually identify these moments of extreme deviation, typically setting the bands to 2 or 2.2 standard deviations from the mean.
Key Considerations for Pair Trading
- Market Neutral Design: Because the trade involves both a long and a short position, the overall direction of the market should have a limited impact on the outcome. Profit is derived from the relative performance between the two instruments.
- Dynamic Correlations: Correlation is not static; it can change over time, even during an active trade. It is crucial to continuously monitor the correlation between your chosen pair. This strategy works for both positively and negatively correlated assets.
- Position Sizing: It is a critical mistake to trade an equal number of shares for each instrument. Instead, you must match the dollar value of both positions. If one stock is priced at $300 and the other at $30, trading 100 shares of each would create a highly unbalanced trade dominated by the higher-priced asset. The number of shares should be adjusted so the notional value of each leg is as equal as possible.
The foundation of any pair trade is the correlation between the two assets. This relationship is the engine of the strategy and requires diligent attention.
Frequently Asked Questions
What is the main purpose of a spread chart?
The primary purpose is to visualize the mathematical relationship between two or more financial instruments. This helps traders analyze relative performance, correlation, and arbitrage opportunities that aren't apparent from looking at individual price charts.
How many instruments can I include in a single spread?
Most platforms enforce a limit, typically allowing a maximum of 10 unique instruments to be combined in a single spread chart calculation.
Why did my spread chart change after I refreshed it?
This is due to repainting. Historical data is built from minute OHLC data, while live data is built from ticks. The internal sequence of ticks, which is missing from historical bars, can cause the chart to recalculate and display slightly different bars upon refresh.
Can I use spread charts for backtesting strategies?
While you can visually assess historical performance on a spread chart, automated backtesting may be complex due to the potential for repainting. It's essential to understand how your specific platform handles historical spread data before relying on it for automated strategy testing.
Is pair trading completely risk-free?
No, it is not risk-free. The primary risk is "correlation breakdown," where the historical relationship between the two assets dissolves, and the prices do not revert to their mean. This can lead to losses on both the long and short positions simultaneously.
How do I calculate the correct position size for a pair trade?
To achieve dollar neutrality, calculate the position size by dividing the desired dollar amount for the trade by the current price of each stock. This will give you the number of shares to buy or sell for each leg to ensure both positions have a similar monetary value.