When I was starting out in trading I worked at a company where most of the traders were “spread traders” in the futures markets. They would trade either cash vs. futures or different futures expirations against each other. So, for instance, if you had future F1 that expired in september, and future F2 on the same underlying product that expired in december, they would define the spread between them F1-F2, and basically, try to buy that spread and sell it (or sell it and then buy it) over and over again. While F1 and F2 were whipping around, F1-F2 would tend to be pretty steady. The bid/ask spread of F1-F2 was determined by the volatility of F1 and F2, but the volatility of F1-F2 was much lower, so the bid/ask of F1-F2 was large compared to its volatility which is a recipe for juicy trading. So, anyway, these people wanted to me trade equities this way, but I had a super hard time with it. I would take two equities (E1 and E2) that were say 90% correlated, do the regression to get the ratio (r), and then start thinking about E1-rE2 as a spread just like I was used to. What I realized is that for 90% correlated instruments the spread volatility is 31% of the volatility of the naked instrument, which is still large compared bid/ask. The individual instruments that the futures traders were spreading were nearly 100% correlated, which is basically the requirement to have a spread market that you can reasonably talk about.
When I was starting out in trading I worked at a company where most of the traders were “spread traders” in the futures markets. They would trade either cash vs. futures or different futures expirations against each other. So, for instance, if you had future F1 that expired in september, and future F2 on the same underlying product that expired in december, they would define the spread between them F1-F2, and basically, try to buy that spread and sell it (or sell it and then buy it) over and over again. While F1 and F2 were whipping around, F1-F2 would tend to be pretty steady. The bid/ask spread of F1-F2 was determined by the volatility of F1 and F2, but the volatility of F1-F2 was much lower, so the bid/ask of F1-F2 was large compared to its volatility which is a recipe for juicy trading. So, anyway, these people wanted to me trade equities this way, but I had a super hard time with it. I would take two equities (E1 and E2) that were say 90% correlated, do the regression to get the ratio (r), and then start thinking about E1-rE2 as a spread just like I was used to. What I realized is that for 90% correlated instruments the spread volatility is 31% of the volatility of the naked instrument, which is still large compared bid/ask. The individual instruments that the futures traders were spreading were nearly 100% correlated, which is basically the requirement to have a spread market that you can reasonably talk about.