Trading Strategy: Pairs Trading

CFDs allow traders to gain access to a strategy that involves matching two stocks against each other; one through a long and the other a short position.

When a pair’s trade is opened a hedge is created so profits are made on the movement in price of the long position verses the short position. The offsetting nature of this removes the impact of overall market or sector movements. If the overall market was to move in a particular direction the trader should not be impacted since a gain or loss would be off set.

The strategy is most successful when two highly correlated shares are matched. Finding suitable stocks can involve either fundamental or technical factors to measure correlation and divergence. Historical data can be used to indicate a mean price or comparable ratios such as Price to Earnings. From this information a trader can attempt to profit from being long in the share that is below the mean or underpriced and short the share that is above the mean or overpriced. Profi ts can be made on both positions if the shares revert to the mean or converge.

Pairs trading are quite simple and not expensive to setup. The opposite trades helps reduce overnight charges as the short position results in positive financing that can be used to partly cover the cost of the long position. To further reduce costs and reduce risk the position size for each trade should be hedged and matched equally.

An example of shares that may be suitable for pairs trading is selecting two highly correlated stocks such as National Australia Bank and Commonwealth Bank. Traditionally both stocks should move together as their businesses are similar.