What is pairs trading?

August 18, 2010, 5:36 pm By Kathy Lien kathylien

When you are pairs trading, it is important to be aware that more margin may be required

Contracts for difference, or CFDs, are leveraged trading instruments that have recently received a great deal of attention. There are many ways to trade CFDs, but one of the most popular is pairs trading.

In pairs trading, you buy one instrument and short another at the same time, because you think one will outperform the other. If you are an investor who is not sure where the general market is going, but you have a view on how one company or one sector will perform against another, then you may want to consider pairs trading.

Many professional traders (including hedge funds) are big proponents of pairs trading, because it doesn't matter whether the market rises or falls - only how one position performs relative to another. In order for this to work properly, the long and short positions need to be of equal value.

The different combinations

There are many different combinations in pairs trading. Some of the most popular pairs are different companies in the same sector and equity indices of different countries. For example, let's say you're not sure whether the Australian 200 Index has finally hit a bottom, but you strongly believe that Australian stocks will outperform US stocks over the next month.

You could place a pairs trade by buying the Australian 200 Index and shorting the same amount of the US stock index (SPX 500). With this trade, both the AU and US indices could fall, but your profits and losses would be determined by how much one index falls against the other.

Another way to approach pairs trading is to take positions on two companies within the same sector. Once again, you are looking for one company to outperform the other, whether you base your analysis on fundamentals or technicals. So, if you consider yourself knowledgeable about the resources sector, you might consider placing a pairs trade on the relative performance of BHP against Rio Tinto.

Coming out on top

For example, let's say you expect the scaling down of Chinese purchases of Australian raw materials to harm Rio Tinto - you might consider a long BHP trade and a short Rio trade. Even if the entire industry booms, you would still come out ahead if BHP shares rise more than Rio's.

These types of trades can be taken from a short- or long-term perspective. Long-term trades can express a view on the relative performance of two companies over the course of a few months, while short-term trades can be done in anticipation of earnings or news releases.

In general, CFDs are highly volatile instruments and unless you are using them for hedging purposes, they are more suited to short-term trading. When you are pairs trading, it is important to be aware that more margin may be required than on a single position.

The possibilities are endless

The possible combinations to trade are endless because of the large number of instruments available for CFD trading. In addition to indices and individual shares, you can also trade futures, commodities and currencies through CFDs.

What CFD combination do you think you could pairs trade and why? (Share your views below)

Want to learn more about trading CFDs? Download GFT's free CFD guide, get a risk-free practice account and visit gft.com.au for more information. Ready to start trading? Open an account with GFT with as little as $275. Don't forget to follow Kathy's commentary on FX360.com and Twitter.

Stock Quotes

e.g. BHP, CBA