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Most stock market investors buy shares, and want the market to rise. A smaller group take short positions, and want the market to fall. Pairs traders don’t mind what the market does, as long as they choose the stronger of a pair of related securities.

Pairs trading seeks to profit from relative performance. The trader buys one instrument and simultaneously sells another. Whether the market rises or falls is irrelevant: it’s the relationship between the pair of securities that matters to the pairs trader. As long as the trader buys the outperformer, the trade will make money.

Retail investors can easily use contracts for difference (CFDs) to trade pairs. Pairs trading has “really come to the fore” in the bear market of the last 18 months, says Alex Douglas, head of business stgelopment and market strategist at CFD provider City Index. “It’s a strategy that people tend to employ when there’s a lot of uncertainty which way the market is going.

“The beauty of a pairs trade is that it removes market risk, because whether the trade makes money depends on you buy the security that is going to outperform and you sell the one that is going to underperform. For example, you might buy BHP and sell Rio Tinto, because you expect BHP to outperform Rio. It doesn’t matter if both stocks rise or both fell in a heap: as long as the relationship between the two moves in the way you expect, you will make money.”

If BHP falls less than Rio, the trader still comes out in front. “If Rio falls, you’re making money because you’re short Rio. Even though you’re losing money on the position that you bought – because BHP is falling – you’re offsetting that with making money on Rio falling,” says Douglas.

Pairs trading is relatively cheap, he says, because there is an offset factor with the financing. “Although you’re paying out a small financing charge on the long position (in this case, BHP) you’re earning some financing income on the short position (Rio). The offset is not 100 per cent, but it will to some extent defray the cost of the trade. That means a pairs trade is cheaper to leave open than a purely long position,” says Douglas.

At the moment, there is a lot of interest in pairs-trading indices, he says. “Investors have been prepared to back the Australian market to outperform the US market, so they’ve been buying the ASX 200 cash CFD and shorting either the S&P 500 CFD, or the Dow Jones CFD.

“More recently they have been closing that out and going short on the Japanese index, the Nikkei 225 CFD. The stronger backing is for the Australian market, but in terms of relative performance, people have decided that maybe the Aussie performance is going to be stronger versus Japan than against the US.”

Chris Weston, head of institutional dealing at CFD provider IG Markets, says pairs trading is “a good way for people to get into the market” at the moment. “It’s cost-effective, but it’s also less risky than just having exposure to one trade. We find that traders like to use pairs that are correlated. You might have Stockland against Mirvac, BHP against Rio, IAG against QBE. It’s pretty easy to buy and sell an equal dollar amount of each – you’re just trading your view that one will outperform the other.”

Weston says traders can also take positions on sectors as well, using CFDs over the GICS sectoral indices – either against the overall market, or against another sector.

“Say you’re bearish on oil, you think the energy sector has got ahead of itself, and it will underperform the market, you’d short the energy index and buy the ASX 200 index. Or 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.”

If trader is trading sectors against the market, and wants the exposure to match perfectly, Weston says weightings must be considered: for example, the fact that the energy sector is about 8 per cent of the ASX 200 index.

“You can do a pairs trade really on anything that there is CFDs on, although currencies are already a pairs trade. Say in commodities, if you think copper is going to underperform against gold, you can sell copper and buy gold, and make sure the underlying exposures net off. You need to make sure that the dollar value of the exposures needs to be equal weighting.”

Weston says index pairs trading is so popular, IG has introduced a couple of pre-set pairs trades in index trading. “We offer a FTSE-DAX and FTSE-Dow Jones. You’re trading one CFD, a spread-based product, and you buy or sell it depending on what you think will happen there. It’s a pre-determined margin and a fixed-rate cost per transaction, so you simply choose your trade size depending on your risk,” he says.

Below are some examples of pairs trading supplied by IG Markets.

Examples of pairs trades

1) The trader believes that oil is going to fall in price and thus the ASX Energy sector is going to underperform the ASX 200 index. The trade is buy the ASX 200, sell the energy sector.
 
Energy sector index currently trading at 5260*

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

ASX 200 currently trading at 4470*

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, trader sells one energy sector and buys two ‘mini’ contracts on ASX 200.
 
Asssume energy sector trades down 10 points to 5250 and ASX 200 stays flat at 4470 – trader makes $100.
 
ASX: 10 x 4470 = $44,700 (no change)
Energy: 10 x 5250 = $52,500 (a drop of $100)
 
* hypothetical levels
 
2) The trader believes NAB is trading on more attractive multiples than CBA, and thus will outperform CBA as offers more upside from a valuation perspective. The trade is buy NAB, sell CBA.
 
To balance exposure, $10,000 equity is applied on either side. Margin deposit of $1,000 (CFD margin of 10 per cent).

NAB is trading at $27, CBA at $45. $10,000 equals 370 NAB shares and 222 CBA shares.
 
Using CFDs, ‘sell’ 222 CBA shares, ‘buy’ 370 NAB shares.

This costs 0.1% of the total equity: $10 on either side = $40 (‘round trip’ buying/selling: $10 x 4)

Assume NAB rises to $28 and CBA rises to $45.50.

370 NAB shares @ $28 = $10,360.
222 CBA shares @ $45.50 = $10,101

Profit = $259
Minus Cost = $40
Gross profit = $219 

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