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Looking for a CFD trading strategy with a difference? How about pairs trading?

by , 17 October 2014

If you focus your analysis on one particular sector, this is a good trading strategy for you to consider.

Pairs trading involves going long on one stock and short on another stock. And contracts for difference (CFDs) are great for the job.

So how does pairs trading work? And why it is a trading strategy worth considering?

Let's take a closer look…


What is pairs trading?


Pairs trading is when your analysis leads you to believe that one share is expensive in comparison to another share within the same sector that looks cheap.

For example, if you were looking at mobile phone providers, you might find a pairs trade opportunity with MTN and Vodacom.

If you find such a pair of shares, you can use CFDs to go long the cheaper share and at the same time, go short on the expensive share.

The idea behind pairs trading is that when the share prices correct to their true value, you’ll profit from both the long and the short trade.

One of the advantages of pairs trading is they tend to be less volatile than trading just one share.


How pairs trading works


If you put a trade on one-for-one, then the performance of your pairs trade will skew to the performance of the more expensive share.

So you need to ensure you trade an equal pair, in other words a neutral pair.

A neutral pair is when the two shares are weighted equally according to the spread ratio. The spread ratio is one share price divided by the other share price.

Let’s have a look at how the spread ratio works with an example…

You decide to short Mobile Giant Company at R37.40 and buy Big Network Company at R100. As you can see, the share prices are different. So a 5% movement in one of the company’s share price isn’t the same as a 5% movement in the other company’s share price.

So the first thing you need to do is calculate the spread ratio. In this case it’s R37.40/R100.00.

That works out at 1 Big Network Company CFDs to 0.374 Mobile Giant Company CFDs. As you can’t trade fractions of CFDs, you need to weight the pair.

In this example, you’d sell 1,000 Big Network Company CFDs and buy 374 Mobile Giant Company CFDs.

So there you have it. Pairs trading, a CFD trading strategy with a difference.

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Looking for a CFD trading strategy with a difference? How about pairs trading?
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