If you have been struggling with the volatility in your trading accounts lately then perhaps it is time to take a look at pairs trading using CFDs. Pairs trading can dramatically reduce the impact of daily market swings on your account, is market neutral and can deliver profits in both a rising and falling markets.
What is Pairs Trading?
Pairs trading involves buying one share (trading long) and selling a second share (trading short). The long position in one share is matched with a similar sized short position in another share. If you believe BHP will outperform RIO, then you could buy $50,000 BHP and sell $50,000 of RIO. You then profit from the difference in performance between the two shares.
Buy the share/s that you believe are stronger and sell the share/s that you believe are weaker. If the market rises, all shares are likely to rise but the strong share should rise more than the weak share. This reverses when the market falls because the weak share is likely to fall faster than the strong share. This strategy will usually under perform a straight long position when the market is rising but will minimise losses when the market falls.
Trading currency is one form of pairs trading because a currency is always traded in relationship to another currency. Traders can trade the relationship between the Australian dollar and the United States dollar. If your view was that the US dollar was going to outperform the Australian dollar, then you would buy the US dollar and sell the Australian dollar to the same dollar value. Your profit or loss is then dependent on the relative performance of the two currencies and is unrelated to the performance of either currency to another currency, for example, the Euro.
When pairs trading using CFDs you will receive interest on the share that you have sold short and you will have to pay interest on the share that you have bought for the long position. For example if the interest charged is the RBA base rate + 2 per cent on long positions and RBA base rate – 2 per cent on short positions, your net interest charge will be the difference of 4 per cent when using this strategy.
The Market Analyser software has two very useful charting features that can assist with your pairs trading. The obvious “Pair chart” displays the red line below the graph showing the relationship of the two shares. The “Overlay chart” draws the chart of the second share as a line on the original share. In the example below the base chart is BHP and the overlay is RIO.
From studying this chart it becomes clear that BHP and RIO follow each other fairly closely, most of the time, but there are times when the two charts diverge. At the very right of the chart BHP has been underperforming RIO, which can be seen by the pairs chart in the lower screen falling away during June. At the same time the overlay chart of RIO is moving higher more rapidly than BHP. This is reversing the out performance of BHP through May, where BHP fell less than RIO did. If you were long BHP and short RIO you would have made money in May, but lost money in June. It is important that the pairs chart in the lower window is rising or falling for you to make money, it is unimportant what the price is actually doing.
Pairs trading can provide you with the opportunity to profit from differences in the performance of two shares when trading with CFDs. Market Analyser has two tools that can assist you to find opportunities to pairs trade, by plotting the relative performance of the shares you are interested in. CFDs are the ideal instrument to use for pairs trading as CFDs can be easily short sold. In addition to this pairs trading with CFDs reduces the volatility and can smooth out your overall returns.
By Jeff Cartridge
Education Manager
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Risk Disclaimer
Be aware that CFDs are leveraged products which carry a high level of risk to your capital, as it is possible to incur losses that exceed your initial investment. Therefore CFDs may not be suitable for your level of acceptable investment risk. Before proceeding with CFD trading, ensure you fully understand the risks involved, otherwise seek independent financial advice
