Discover how you can pairs trade using Contracts for Difference

Pairs trading is the action of a trader buying one CFD and simultaneously selling another. As the investor is long one Contract for difference and sold the other they are not affected by broader market price changes instead they are subject to the price changes of the pair of securities which they are trading. As long as the investor buys the outperforming security or sells the under performing security they will generate profits.

Most traders buy Contracts for difference with the view that the market will rise, few traders take sold positions with the opinion the market will fall. Pairs traders are indifferent to market direction and do not mind which direction the market moves as long as they select a strong pair of correlated securities.

Pairs trading has become common 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 reason for this is that it eliminates market risk, whether the trade generates profits will depend on whether the trader buys a CFD that will outperform or goes short a Contract for difference that will under perform. A common illustration of this would be going long Commonwealth Bank (CBA) and going short ANZ Bank (ANZ), because the trader anticipates that CBA will outperform ANZ. Should both stocks rise or fall the trader will be indifferent, however should CBA rise and ANZ fall as the trader anticipated, the trader will generate profits. 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 income on their short position. Take the above example for instance, when the trader opens the long CFD position on CBA they will pay a small financing charge however when the trader sells the ANZ Contract for difference they will receive financing income. Although the offset is not 100% it will most certainly lessen the expense of the trade. In many ways pairs trading as a short to medium term strategy and can be less expensive and less risky than simply opening a naked long or short position.

Pairs trading is not only commonly used when trading equity Contracts for difference it has also become extremely popular for use with indices. When using Contracts for difference over indices investors can take the expectation that one index will outperform the other. An illustration of this may be the US market versus the Australian market. In this example you would buy the ASX 200 index CFD and sell the S&P 500 index Contract for difference with the view that the Australian market will outperform the US market.

Pairs investors use a number of strategies, one of the more typical strategies used is to choose pairs that are correlated, for example Stockland against Mirvac or Rio Tinto against BHP Billiton. It is also typical for investors 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 expectation that the resources sector is overvalued compared to to the market and will under perform the market, the trader would short the resources sector and buy the ASX 200 index. Alternatively the trader may feel that the market will give ground and money will move back into the defensive stocks, in this case the trader would buy the health care sector and sell 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.

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