Articles of Interest

Pairs trading is the action of a trader buying one CFD and simultaneously selling another. As the trader is long one CFD and short the other they are not affected by broader market movements instead they are subject to the price movements of pair of securities which they are trading. As long as the trader buys the outperforming security or sells the underperforming security they will make money.

Most traders buy CFDs with the expectation that the market will rise, few traders take short positions with the view the market will fall. Pairs traders are indifferent to market direction and don’t mind which way the market moves so long as they choose a strong pair of related securities.

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

Most traders adopt pairs trading strategies when there is uncertainty as to the direction of the market. The reason for this is that it removes the market risk, rather whether the trade makes money will depend on whether you buy a CFD that will outperform or sell a CFD that will underperform. A typical example of this would be buying Commonwealth Bank (CBA) and selling ANZ Bank (ANZ), because you expect that CBA will outperform ANZ. Should both stocks rise or fall you will be indifferent, however should CBA rise and ANZ fall as you expected, you will make money. If CBA falls less than ANZ you will make money likewise if CBA rises more than ANZ you will also make money. 

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 you earn a financing income on your short position. Take the above example for instance, when you open your long CFD position on CBA you will pay a small financing charge however when you go short the ANZ CFD you will receive financing income. Although the offset is not 100% it will most certainly reduce the cost of the trade. In many ways pairs trading as a short to medium term strategy and can be much cheaper and less risky than simply opening a naked long or short position.  

Pairs trading is not only commonly used when trading share CFDs but has also become very popular for use with indices. When using CFDs over indices traders can take the view that one index will outperform the other. An example of this may be the US market versus the Australian market. In this example you would buy the ASX 200 index CFD and sell the S&P 500 index CFD with the view that the Australian market will outperform the US market. 

Pairs traders adopt a number of strategies, one of the more common strategies used is to choose pairs that are correlated, for example Stockland against Mirvac or Rio Tinto against BHP Billiton. It is also common for traders to use sector CFDs in their strategy such as the healthcare sector versus the materials sector or energy sector versus the ASX 200 index.  

An example of sector trading would be the resources sector versus the ASX 200 index. You might be of the view that the resources sector is overvalued relative to the market and will underperform the market, you would short the resources sector and buy the ASX 200 index. Alternatively you may feel that the market will retreat and money will move back into the defensive stocks, in this case you would buy the healthcare sector and short the energy sector. When choosing sectors you should consider their weighting within the overall index as this will help you determine the sectors correlation to the overall market. 

Pairs trading can be done on just about anything except currencies which by their very nature are already a pair’s trade. A common pairs trading example is illustrated below.

You have the view that ANZ is undervalued and trading on much lower earnings multiples than CBA, and will therefore outperform CBA. The pairs trade is go long ANZ and short CBA.

You buy a $10,000 worth of CFDs over ANZ and sell $10,000 worth of CBA CFDs. The margin on each position is $1,000 or 10% of the value of the contract.

ANZ CFDs are trading at $22, your $10,000 investment gets you 454 CFDs. CBA CFDs are trading at $52, your $10,000 investment gets you 192 CFDs.

Your pairs trade would be ‘buy’ 454 ANZ CFDs and at the same time ‘sell’ 192 CBA CFDs.

Typically CFD commission rates are $10 or 0.10%, your trade will cost you $10. As the trade consists of four trades (buying and selling) your total commission would be $40 ($10 x 4).

Let’s assume that ANZ rises to $30 and CBA rises to $55. In this scenario you would make a profit on your ANZ position and a loss on you CBA position.  

Your positions would now look like this:

Long  454 ANZ shares @ $30     = $13,620
Short  192 CBA shares @ $55    = $10,560

ANZ profit     = $3,632
CBA loss       = -$576
Commission   = $40
Gross profit   = $3,016