Categorized | CFD trading

CFD Pair Trading

Pair trading is a good strategy because it reduces trading exposure to the market going in a single direction. It also enables traders to make a profit regardless of how their stocks perform, as the strategy depends on the performance of their stocks relative to each other, rather than the performance of their stocks in relation to the market.

While pairs strategies can be performed over a range of asset classes and sectors, an individual pair should trade within the same sector.

Share CFDs pair trading example

Pair trading involves choosing two assets and determining which one will outperform the other. The trader then goes long on the asset that he thinks will do well, and short on the asset he thinks will perform badly.

It is the start of 2011 and you think that silver is looking bullish. Meanwhile, you think platinum has reached its peak, at AUD 1,850, and you think the price will soon correct itself. Using this logic, you decide to go long on silver mining company Silver Mines Ltd, and short on Platinum Australia Ltd.

On January 17th, Silver Mines shares are valued at AUD 0.25 each, while Platinum Australia shares are valued at AUD 0.75 each. To avoid directional bias, you invest AUD 500 in each stock.

Now, as this is a CFD position, you only need to deposit 5% of the total value of the position, which means that your AUD 500 will give you access to 40,000 Silver Mines shares (AUD 500/5%/AUD 0.25 = 40,000) and 13,333 Platinum Australia shares (AUD 500/5%/AUD 0.75).

On March 1st, Silver Mines’ share price rises to AUD 0.39 and Platinum Australia’s shares have fallen to AUD 0.63. You decide to close your position, making a profit on both trades. You close your positions making a total gross profit of AUD 7,199.96.

Silver Mines profit = AUD 0.39 closing price – AUD 0.25 opening price x 40,000 shares = AUD 5,600
Platinum Australia profit = AUD 0.75 opening – AUD 0.63 closing x 13,333 shares = AUD 1599.96

The trend has continued over the year, with silver prices rising by 12.10% in the first half of 2011 and platinum prices dropping by 2.68%. Both companies’ share prices have followed the prices of the metals, with Platinum Australia’s on a downtrend and Silver Mines’ very volatile.

Please note that, for simplicity, this example hasn’t taken overnight financing, commission charges or dividend payments into account. Also, deposits can vary depending on your CFD provider, and usually range from 3% to 10% of the value of your position.

Using pair trading to hedge

Although the above example worked very well, with both trades making a profit, pair trading is usually used as a hedging strategy, meaning that one trade will usually make a loss.

Pair trading usually involves going long on the stock of a company performing well in an industry and going short on that of a company performing poorly in the same industry.

As another example, let’s take Apple and Microsoft. Apple has been trading sideways for the first half of 2011, largely resting between USD 330 and USD 350. In contrast, Microsoft started the year around USD 28 a share, but fell below USD 25 by June. Although shares rose to USD 26 by the end of the month, you aren’t sure that these levels will hold, and think that Microsoft may turn town again.

So, on July 1 you decide to take a long position on Apple and a short position on Microsoft. You decide to invest USD 1,000 in share CFDs on each company. As a CFD position only requires you to deposit 5% of the value of the position, your USD 2,000 will grant you access to 58 Apple shares, now valued at USD 343.26 each (1,000/5%/343.26 = 58) and 768 Microsoft shares, now priced at 26.02 (1,000/5%/26.02).

On July 26th, the shares of both companies have risen – Apple to USD 403.41 per share and Microsoft to USD 28.08 per share. So you have made a profit on your Apple position but, as you were going short on Microsoft you have made a loss on that position. You decide close your positions and take your profits.

Apple profit = USD 403.41 closing price – USD 343.26 opening price x 58 shares = USD 3,488.70
Microsoft loss = USD 26.02 opening price – USD 28.08 closing price x 768 shares = USD 1,582.08
Gross profit = USD 1,906.62

The logic behind pair trading is that, in the event of a downturn, the weaker company will perform worse than the stronger company, and in the event of an upturn, the stronger company will perform better than the weaker company.

As you can see, the profit of the trade with the larger movement (Apple, in the example) will offset the loss of the trade with the smaller one, and secure you an overall profit.

Hedging with CFDs is an excellent way to manage your risk. Although pair trading may not result in your profits being as great as they may have been, had you traded in a single direction, they will reduce your losses and result in more consistent profits over time.

A good place to learn about CFDs is with my favourite CFD trading site, which offers a range of educational tools, including free online seminars and a free demo account of the trading platform. Open your free account today.

CFDs are leveraged products, meaning you can lose more than your original deposit. CFD trading might not suit everybody, so please ensure you understand the risks involved.

Article Source:’ien

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Symbol Bid Ask Spread
EURUSD 1.17440 1.17460 2
GBPUSD 1.31860 1.31890 3
USDCAD 1.26550 1.26580 3
USDJPY 113.680 113.700 2
USDCHF 0.98590 0.98620 3
AUDUSD 0.77800 0.77830 3
NZDUSD 0.69190 0.69240 5
EURGBP 0.89050 0.89080 3
EURCHF 1.15790 1.15820 3
EURJPY 133.520 133.550 3
AUDJPY 88.450 88.500 5
GBPJPY 149.900 149.960 6
XAUUSD 1279.48 1279.88 40
XAGUSD 17.048 17.098 5