Pairs trading is the action of a investor buying one Contract for difference and simultaneously selling another. As the trader is long one CFD and sold the other they are not affected by broader market price changes instead they are subject to the price movements of the pair of stocks which they are trading. As long as the investor buys the outperforming security or sells the under performing security they will make money.
Most traders buy CFDs with the expectation that the market will rise, few investors take sold positions with the expectation the market will fall. Pairs traders do not care about market direction and don’t mind which direction the market moves so long as they select a strong pair of linked stocks.
Pairs trading has become widespread since the introduction of Contracts for difference, prior to this it was not easy for a trader to short sell. Contracts for difference have made pairs trading simple and accessible to the everyday investor.
Most investors use pairs trading strategies when there is uncertainty as to the direction of the market. The motive for this is that it removes market risk, whether the trade generates profits will depend on whether the trader goes long a CFD that will outperform or goes short a CFD that will under perform. A conventional example of this would be buying Commonwealth Bank (CBA) and going short ANZ Bank (ANZ), because the investor anticipates that CBA will outperform ANZ. If both stocks rise or fall the trader will be indifferent, however should CBA rise and ANZ fall as the trader expected, the trader will make money. If CBA falls less than ANZ the trader will generate profits likewise if CBA rises more than ANZ the trader will also generate profits.
There are a number of benefits of using CFDs in your pairs trading strategy. One of the main benefits is the financing offset that will be achieved when the trader earns a financing revenue on their sold position. Take the above illustration for instance, when the trader opens the long CFD position on CBA they will pay a small financing cost however when the trader goes short the ANZ CFD they will receive financing revenue. Although the offset is not 100% it will without doubt lower the expense of the trade. In many ways pairs trading as a short to medium term strategy and can be less costly and less risky than simply opening a naked long or short position.
Pairs trading is not only frequently used when trading equity Contracts for difference it has also become extremely common for use with indices. When using Contracts for difference over indices traders can take the expectation that one index will outperform the other. An example of this may be the US market versus the Australian market. In this illustration you would buy the ASX 200 index Contract for difference and sell the S&P 500 index CFD with the opinion that the Australian market will outperform the US market.
Pairs traders use a number of strategies, one of the more common strategies used is to select pairs that are associated, for example Stockland against Mirvac or Rio Tinto against BHP Billiton. It is also common for traders to use sector Contracts for difference in their strategy such as the health care sector versus the materials sector or energy sector versus the ASX 200 index.
An example of sector trading would be the resources sector versus the ASX 200 index. The trader might be of the view that the resources sector is overvalued relative to the market and will under perform the market, the trader would sell the resources sector and buy the ASX 200 index. Alternatively the trader may feel that the market will retreat and money will move back into the defensive stocks, in this case the trader would go long the health care sector and short the energy sector. When choosing sectors the trader should consider their weighting within the overall index as this will assist the trader decide the sectors correlation to the overall market. Pairs trading can be done on almost any financial instrument but currencies which by their very nature are allready a pairs trade.
Author Resource:
Vist IC Markets website to get your free CFD ebook and find out more about pairs trading CFDs .
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