Given that it effectively removes market risk, it’s hardly surprising that ‘pairs trading’ – where you buy one instrument and simultaneously sell another using contracts for difference (CFDs) – typically comes into its own during periods of heightened share market volatility.
As counterintuitive as it sounds, one of the first things to understand when trading pairs is that market rises or falls are somewhat irrelevant.
When trading pairs, it’s the relationship between the chosen pair of securities that really matters to you the trader.
It’s all about relative performance
What you’re hoping to profit from is ‘relative performance’, and as long as you buy the security that’s going to outperform and you sell the one that is going to underperform, you’ll be in the money.
Given that it’s less risky than just having exposure to one trade, ‘pairs trading’ can be a cost-effective way for investors to get into the market.
You can also take positions using CFDs over sectoral indices, either against the overall market, or against another sector, here’s another example:
You’re bearish on oil, and think the energy sector has got ahead of itself, and will underperform the market, so you short the energy index and buy the ASX 200 index.
Alternatively, you might think that if we are going to have a pullback in Australia, money is going to come back into a defensive sector, so you might buy the healthcare index and short either the materials or the energy sector.
Stocks, currencies, commodities and sectors aside, you can also trade indices – for example the FTSE-DAX or the FTSE-Dow Jones – and buying or selling depending on what you think will happen.
Pre-determined margins and a fixed-rate cost per transaction, means that you can choose a trade size that matches your appetite for risk.
Remember, you can also apply pairs trading to commodities. For example, if you think copper is going to underperform against gold, you can sell copper and buy gold. But to ensure your underlying exposures net off, you need to ensure that the dollar value of the exposures are of equal weighting. Let’s look at a specific example.
Pairing indices
You believe the price of oil is going to fall, and as such the ASX Energy sector is going to underperform the ASX 200 index.
Your trade is buy the ASX 200, sell the energy sector.
Let’s say the energy sector index is trading at 5260
Let’s assume one standard energy sector index CFD contract is a $10 per point movement (i.e. if you short the contract and the sector index falls to 5259 you make $10).
Exposure 5260 x10 = $52,600
Let’s assume the ASX 200 is trading at 4470
Let’s assume one ‘mini’ index CFD contract equals $5 per point. Exposure 4470 x 5 = $22,350.
To balance exposure: 52,600/22,350 = 2.3 contracts.
Therefore to balance, you sell one energy sector and buy two ‘mini’ contracts on ASX 200.
Let’s assume the energy sector trades down 10 points to 5250 and ASX 200 stays flat at 4470 – which means you makes $100.
ASX: 10 x 4470 = $44,700 (no change)
Energy: 10 x 5250 = $52,500 (a drop of $100)
Pairing currencies
You can make a pairs trade on pretty much anything that there are CFDs on, and currencies – which are paired by default – are no exception. Most FOREX trading strategies revolve around pairing currencies that are gaining strength against those that are losing strength.
Major Forex currencies paired with the US dollar are the most liquid and most widely traded currency pairs in the forex market, and as such will typically will have the tightest spreads.
Major Forex currency pairs
- EUR/USD – Euro vs. the U.S. dollar (Fiber)
- GBP/USD – British pound vs. the U.S. dollar (Sterling, Cable)
- AUD/USD – Australia dollar vs. the U.S. dollar (Aussie)
- NZD/USD – New Zealand dollar vs. the U.S. dollar (Kiwi)
- USD/JPY – U.S. dollar vs. the Japanese yen (the Yen)
- USD/CHF – U.S. dollar vs. the Swiss franc (Swissie)
- USD/CAD – U.S. dollar vs. the Canadian dollar (Loonie)
The ‘crosses’
Then there are the ‘crosses’ which are those pairs that are not paired vs. the US dollar, these include:
- AUD/CAD – Australian dollar vs. the Canadian dollar
- AUD/CHF – Australian dollar vs. the Swiss franc
- AUD/JPY – Australian dollar vs. the Japanese yen
- AUD/NZD – Aussie dollar vs. the New Zealand dollar
- CAD/JPY – Canadian dollar vs. the Japanese yen
- CHF/JPY – Swiss franc vs. the Japanese yen
- EUR/AUD – Euro vs. the Australian dollar
- EUR/CAD – Euro vs. the Canadian dollar
- EUR/CHF – Euro vs. the Swiss franc
- EUR/GBP – Euro vs. the British pound
- EUR/JPY – Euro vs. the Japanese yen
- EUR/NZD – Euro vs. the New Zealand dollar
- GBP/AUD – British pound vs. the Australian dollar
- GBP/CHF – British pound vs. the Swiss franc
- GBP/JPY – British pound vs. the Japanese yen
- NZD/JPY – New Zealand dollar vs. the Japanese yen
Pairing stocks
More often than not, traders like to use pairs that are correlated to the same sector, for example, you might have Stockland (ASX: SPG) against Mirvac (ASX: MGR); BHP Billiton (ASX: BHP) against Rio Tinto (ASX: RIO); Insurance Australia Group (ASX: IAG) against QBE Insurance Group (ASX: QBE).
It’s pretty easy to buy and sell an equal dollar amount of each, and what you’re trading is the expectation that one will outperform the other.You buy Commonwealth Bank of Australia (ASX: CBA) and sell Australia and NZ Banking Group (ASX: ANZ), on the pretext that CBA will outperform ANZ.
Whether both stocks rise or fall is immaterial, what matters to you as a pairs trader is that the relationship between the two stocks moves as you expect them to.
For example, you believe CBA is trading on more attractive multiples than ANZ, and as such will outperform ANZ – given that it offers more upside from a valuation perspective.
Your trade is buy CBA, sell ANZ.
To balance your exposure, $10,000 equity is applied on either side. Margin deposit of $1,000 (CFD margin of 10%).
CBA is trading at $27, ANZ at $45. $10,000 equals 370 CBA shares and 222 ANZ shares.
Using CFDs, ‘sell’ 222 ANZ shares, ‘buy’ 370 CBA shares.
This costs 0.1% of the total equity: $10 on either side = $40 (‘round trip’ buying/selling: $10 x 4)
Assume CBA rises to $28 and ANZ rises to $45.50.
370 CBA shares @ $28 = $10,360.
222 ANZ shares @ $45.50 = $10,101
Profit = $259
Minus Cost = $40
Gross profit = $219
Get educated
Pairs trading, whether via CFDs or some other method is not for the faint hearted, it requires patience, experience and above all a heightened appetite for risk. That’s why your first ‘port of call’ is often a trading platform that allows you to shadow box, until you really know what you’re doing.
You shouldn’t be speculating on pairs trading until you’ve mastered the dynamics of different trades and strategies, understand the importance of stops losses and become fully aware heightened risks associated with trades that don’t turn out the way you’d planned.
