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Pairs trading

What is it?

Pairs trading is a strategy that involves trading share CFDs in two comparable companies from the same sector in the hope that one goes up and the other down. The strategy can be thought of as an extension of buying the best stock, with a simultaneous trade involving selling the least attractive stock. The aim of both buying and selling stocks in the same sector in equal dollar amounts is to make a profit on both positions as well as reduce the risk of a big rise or fall in the market.

Case study

Jim’s portfolio has been under pressure for the last couple of months due to the steep sell off in equities and rising interest rates. Given the recent share market correction and a reduction in his equity he considers it is time to take a more market neutral (long and short) approach to his trading. He aims to do this by trading pairs on stocks he is familiar with.

Jim notices IAG’s share price has generally been underperforming its larger rival, QBE Insurance. After researching, he decides to buy QBE and sell an equal dollar amount of IAG. He thinks the pair has the potential to move 10% in his favour:

On May 1 2007, shares / CFDs in QBE are trading for $31.10. Jim buys 1,000 QBE CFDs, for a total exposure of $31,000. At the same time he sells (go short) 5,183 shares in IAG for a total exposure of $31,098.

Over the course of the next 6 weeks, Jim is proven correct as QBE rises and IAG falls.

Risk

The risk with pairs trading is that if the pair does not move as expected, losses will accrue on one or both legs. This can be limited by the use of stop loss orders, closing the position or changing the trade from a pairs trade to keeping only one position open.

Summary:

Pairs trading as a strategy has been around since the 1970s. With the advent of CFDs this strategy is now available to all investors to take advantage of both outperforming and underperforming stocks. Importantly pairs trading reduces overall market risk making this style of trading a valuable addition other strategies.

More about CMC Markets

CMC Markets is a pioneer of CFD trading in Australia. Our goal is to empower Australian traders by giving you access to CFDs over Australian and global markets and the ability to trade on leverage and potentially profit in almost any market condition. We run regular CFD introduction seminars and education courses around Australia for traders new to CFDs and are committed to providing a cost effective CFD trading service. Click here for more info or to start trading CFD's.