How I Use Spreads in Volatile Markets

The volatility in the markets this month has reinforced for us the huge value of trading spreads.  With spreads, you are betting on relative performance rather than on absolute performance.  This means you can express a view without taking on unwanted risk.  When the markets are moving with 10 to 15% volatility, market risk is minimal.  However, when the $VIX is at 40, eliminating unwanted risk is so important.

As an example, we bought $TGT the morning of August 17 when it reported good earnings.  To hedge out market and sector risk, we sold an equal amount of $XRT the Retailers ETF.  Here is the chart of $TGT over the two days August 17 to 18:

As you can see, $TGT traded down during August 17 and opened lower the morning of August 18.  However, the index traded down more over the two day period, so our trade was profitable.  Here is the chart of the spread $TGT-$XRT over the same 2-day period.  We bought the spread at 4.3 and sold it at 6.2:

This is a very different picture, isn't it?

Written by Jennifer Galperin. Follow me on Twitter and StockTwits.