Pairs Trading with Spread Bets

Trading Guides

What is Pairs Trading?

With pairs trading you take two opposite positions on a pair of related markets, e.g. you could buy Shell and sell BP.

Therefore, as long as the difference in share price between Shell and BP increases you make a profit, it doesn’t matter whether the overall markets move higher or lower.

(If the share price difference of the two oil firms narrows then you’ll make a loss).

The aim is to create an overall profit with the understanding you’ll lose on one trade but win more on the other.

Pairs Trading Example

Step 1: Choose Your Markets

Choose two markets that correlate with each other, i.e. two markets that have a strong tendency to move in line with each other on a day-to-day basis. E.g. Brent crude oil and US crude oil.

For the following example though, let’s say that Bank ABC and Bank XYZ represent a suitable pair of related stocks.

Step 2: The Trade

Next, decide if one of the two stocks is undervalued or overvalued compared to the other.

If you think Bank ABC is undervalued compared to Bank XYZ then you would make two equivalent sized trades, i.e.:
  • arrow_forwardGo long of (buy) Bank ABC, and
  • arrow_forwardShort (sell) Bank XYZ
Step 3: Trade Size

These two opposing spread bets need be worth roughly the same amount.

For example, if your position on Bank ABC is worth £3,200 (400p share price x £8 per penny stake), your position on Bank XYZ should also be worth £3,200.

Therefore if Bank XYZ’s share price is 800p, your stake should be £4 per penny (800p share price x £4 per penny stake = £3,200)

It’s important that the trades are equal in size, otherwise you are just reducing the risk of the larger trade.

With equal trade sizes you create a situation where you can make a profit irrespective of whether the underlying markets move higher or lower.

Pairs Trading Example: The Result

Again, Pairs Trading is all about the difference (or differential) between the two markets:
  • arrow_forwardIf the overall market moved up and the share price of Bank ABC (the undervalued stock) moved higher more quickly then Bank XYZ you would make a profit.
  • arrow_forwardIf the overall market moved up and Bank XYZ’s moved higher more quickly then Bank ABC’s share price, i.e. the difference in share price narrowed, you would make a loss
  • arrow_forwardIf the overall market fell but Bank ABC didn’t not drop as quickly as Bank XYZ you would make a profit.
  • arrow_forwardIf the overall market fell but BANK ABC fell more sharply than Bank XYZ you would make a loss

Risks with Pairs Trading

  • warningObviously the trade could go against you e.g. you might want to price between two stocks to widen when it narrows instead (and vice versa)
  • warningYou need to manage two separate trades and if you are losing a lot on one trade (or if the market gaps against you) then your spread betting firm may close one of the trades. To help protect yourself, make sure you have enough money in your account to cover sharp moves for both trades
  • warningThere is the risk that nothing happens, e.g. the banking sector may move around a lot but the difference between the two bank share prices doesn’t alter much. If so, you will end up paying overnight financing (rollover) fees on two trades. You will also lose if you close the trades yourself, i.e. you lose on the width of the spread.
Note, this might not be a bad thing. Rollover costs aren’t that bad with financial spread betting and spreads can be quite tight these days.

Also, as usual, if the market(s) you’re trading isn’t doing what you expect it might be better to get out of your trade(s) with a small loss.

Pre-Made Pairs Trades: Differential Markets

The spread betting firms, being generous folk, have created a number of ‘differential markets’. These are essentially pairs trade and include:
  • arrow_forwardBrent Crude vs US Crude Oil Differential
  • arrow_forwardFTSE / DAX Differential
  • arrow_forwardFTSE / Dow Jones Differential
  • arrow_forwardDow vs DAX Differential
  • arrow_forwardCAC vs DAX Differential
E.g. you can take a position on the FTSE 100 to out perform the Dow Jones (or vice versa) Likewise, you can speculate on the price difference between Brent crude oil and US crude oil to widen or narrow. These manufactured pairs trades can be reasonably popular and are useful because:
  • arrow_forwardYou only need to manage one trade
  • arrow_forwardThe spread of a differential market is often tighter than the combined spread of two individual markets
The negative is that you can’t make equal trade sizes.

How to Practice Pairs Trading

If you’ve not tried pairs trading (or differentials), it’s easy to give it a test using a demo (practice) account that most spread betting companies offer.

AuthorAlex Turner

Senior Editor, SpreadBetMagazine

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