Understand How To Pairs Trade With Contracts For Difference

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

Most investors buy CFDs with the expectation that the market will rise, few investors take sold positions with the view the market will fall. Pairs traders do not care about market trend and don’t mind which way the market moves as long as they choose a strong pair of linked shares.

Pairs trading has become common since the introduction of CFDs, prior to this it was complicated for a trader to short sell. CFDs have made pairs trading simple and accessible to the everyday investor.

Most traders use pairs trading strategies when there is uncertainty as to the trend of the market. The motive for this is that it removes market risk, whether the trade makes money 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 example of this would be going long Commonwealth Bank (CBA) and going short ANZ Bank (ANZ), because the investor expects 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 expected, the trader will generate profits. If CBA falls less than ANZ the trader will make money 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 Contract for difference position on CBA they will pay a small financing cost however when the trader goes short the ANZ Contract for difference they will receive financing revenue. Although the offset is not 100% it will without doubt decrease the cost of the trade. In many ways pairs trading as a short to medium term strategy and can be cheaper and less risky than simply opening a naked long or short position.

Pairs trading is not only regularly used when trading equity CFDs it has also become exceptionally popular for use with indices. When using CFDs over indices traders can take the view 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 Contract for difference and sell the S&P 500 index Contract for difference with the opinion that the Australian market will outperform the US market.

Pairs investors adopt a number of strategies, one of the more common strategies used is to choose pairs that are associated, for example Stockland against Mirvac or Rio Tinto against BHP Billiton. It is also common 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 illustration of sector trading would be the resources sector versus the ASX 200 index. The trader might be of the view that the resources sector is overvalued relative to the market and will under perform the market, the trader would sell the resources sector and buy the ASX 200 index. Alternatively the trader may feel that the market will retreat and funds will move back into the defensive securities, 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 whole index as this will help the trader determine the sectors correlation to the overall market. Pairs trading can be done on almost any financial instrument except currencies which by their very nature are allready a pairs trade.

To find out more about CFDs visit our pairs trading page and download our educational guide.

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