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 ExampleStep 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.: 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:
Risks with Pairs TradingNote, 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 MarketsThe spread betting firms, being generous folk, have created a number of ‘differential markets’. These are essentially pairs trade and include: 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: The negative is that you can’t make equal trade sizes.
How to Practice Pairs TradingIf 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.
Remember: Spread betting, CFDs and forex trading carry a high level of risk. You can lose more than your initial investment. These products are not suitable for all investors. Only speculate with money that you can afford to lose. Make sure you fully understand the risks involved and seek independent financial advice where necessary.