Quote from Lucias:
Thanks for link. I think your explanation is poor though.
There are typically 2 ways to trade spreads: relative strength (you expect one to outperform) or mean reversion (expect spread to collapse). If you play relative strength you buy A hoping it continues to outperform B. If you play mean reversion then you sell the stronger and buy weaker.
The basic idea behind spreads for mean reversion is the law of one price. Basically, similar products are interchangeable. In terms of relative strength, there are many ideas behind that too. One might might look for fundamental reasons, for example, might think company A is stronger then B and will outperform. There are many books on spreads at Amazon.
What Maverick has spoke about in spreads (in relation to me and others), is how proprietary firms will trade spreads. Often for example spreading a cash market with futures. This could be for arbitrage or something longer term. You might for example create a basket of stocks that you think will outperform the indices but you're making a relative bet, so you buy stocks and sell the futures.. Or you could spread a future against a future.. creates a calendar spread.
Typically for pairs for mean reversion.. you want them to have some correlation, a high correlation to be exact. You want a high correlation because it implies the stocks move together. A high correlation isn't enough though, they need to get "out of line" at times to make a profit. FOR relative strength spreads, you want an inverse correlation.
