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Use this simple strategy to stay protected and profit in uncertain markets

by , 06 December 2012

Recently, while having a drink after an action cricket match in Sandton, one of my team mates, Albѐ – a man with an ability to spin a cricket ball a ridiculous amount and a real passion for trading the markets – told me that he’d read a report talking about a great “pair trade” opportunity.
  • Pair trading is a great way to profit in uncertain times
  • Make sure you get the weighting right to get pair trading to work for you!
  • This week’s broker view on the economic calendar

from Warren Jeffery, Editor, Spread Trader

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Dear reader,

Recently, while having a drink after an action cricket match in Sandton, one of my team mates, Albѐ – a man with an ability to spin a cricket ball a ridiculous amount and a real passion for trading the markets – told me that he’d read a report talking about a great “pair trade” opportunity.

Albѐ asked me: “What is a pair trade and why would a trader place one?”

Today, I thought I’d share my answer with you…

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Pair trading gives you a great way to profit in uncertain times

As I explained to Albѐ, sometimes it can be difficult to find a trading opportunity when you’re uncertain which way the market is heading.

After all, if you’re not sure if the market is heading up or down, how can you place a trade?

So what should you do?

This is where pair trading comes in.

Let’s look at an example to explain…

Say you decide that Vodacom looks like it’s run too hard. You want to go short of Vodacom, but the problem is, the market or sector, as a whole, is looking strong. And if the market as a whole were to rise, it would drag Vodacom with it and your short trade could become a loser.

This is where your pair trade comes in.

Because you believe Vodacom has run too hard, you go short the telecoms company using CFDs or single stock futures.

But then… To protect yourself from a market or sector related move, you go long of a share from the same sector. Let’s use MTN for our example.

So, for your pair trade, you’d have sold Vodacom and bought MTN CFDs or single stock futures.

This way, if you’re right about Vodacom having run too hard, Vodacom’s share price should come down. And if the rest of the market remains flat, you’ll be able to get out of MTN without making a profit or a loss. This means you’ve profited from the decline in Vodacom’s share price and broking even (or made a small loss after brokerage) on the MTN trade.

But what if the market or sector rises and moves upwards?

In this situation, Vodacom may climb, but considering you thought the share price would fall, it probably won’t climb as much as the rest of the sector.

But your long MTN trade will climb with the sector. And you’ll make a profit as MTN’s price moves up. Hopefully this move will outweigh Vodacom’s up move and the loss you’d make on your short trade.

As you can see, pair trading allows you to trade and stay protected, even when you’re uncertain where the market or sector is heading.
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Make sure you get the weighting right to get pair trading to work for you!

To ensure successful pair trading, you need to choose shares that generally move together but are showing an abnormal deviation in share prices.

And to profit from this deviation, you need to get the weighting right.

By this, I simply mean that you want to place the same rand amount on each trade.

So, let’s just say for the purposes of this example, Vodacom is trading at R100 per share and MTN is trading at R150 per share.

You decide you want to take R9,000 exposure on each trade.

To do this, you’d have to sell 90 (R9,000 ÷ R100) Vodacom shares and you’d have to buy 60 (R9,000 ÷ R150) MTN shares.

This will protect you and will isolate the move you’re looking for.

This is just one strategy showing how you can use CFDs and single stock futures to profit in the fast paced world of trading.

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Now, let’s take a look at the broker view of the numbers for the week ahead.  To do this, I’ve turned to our friend Viv Govender from Vunani Private Clients.

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This week’s broker view on the economic calendar…

by Viv Govender, Senior Analyst, Vunani Private Clients

As I predicted last week the US Fiscal Cliff looks likely to be solved.

Statements from both Republicans and Democrats indicate that they're willing to compromise, which should be sufficient to ward off the crisis for a little while longer.

Unlike the situation in Greece, where no amount of negotiations can resolve the problem, the US is fundamentally strong and minor adjustments to taxation and entitlements could put off a real reckoning for several years.

The US’s two party political system is rather adept at dealing with this sort of crisis, though it also makes longer term co-operation less likely.

In Greece, the economy is fundamentally flawed and will require years, possibly decades, to get back on track. During this time it'll require large inflows from other EU members.  It appears that the other Euro Zone countries are finally starting to think about this.

Also, the Chinese PMI came in above 50, which would seem to indicate that the recent slowdown could be over. This should prove to be positive for mining stocks.

We also saw US Initial Jobless Claims remain above 400k, as the after effect of Hurricane Sandy continued to restrict economic activity on the East Coast of the US. It's likely that we'll see this diminish over the next few weeks and even reverse thereafter, as more people are employed to repair the damage caused by the storm.

Over the week keep an eye out for Consumer confidence numbers out of Germany, France and Italy at the start of the week.

As a whole the Euro Zone rivals the US as a consumer market and these numbers will give us a clue as to the state of the European Consumer ahead of the vital holiday season.

Later in the week we’ll also get inflation number for the same countries as well as the Euro Zone as a whole. Though we are unlikely to see a major spike in inflation, we should still watch this number carefully. Any uptick in inflation would put the entire ECB policy scheme in doubt. Germany in particular has been very adamant that they would not allow inflation to rise unchecked.

From the US we’ll get yet more housing numbers this week. The trend appears to show that sector is improving. The Housing sector has been a drag on the US economy ever since 2008 and a turnaround would be very positive for the world’s largest economy.

We can also look forward to durable goods orders on Tuesday. Though it’s quite a volatile indicator, it does give us insight into capital formation as well as the longer term outlook of the US consumer.

On the local front there are a number releases this week. These include GDP on Tuesday, Private Sector Credit on Thursday and finally the Trade Balance on Friday. Though the GDP figure will garner the most headlines, I would advise also paying close attention to the other 2 figures.

The Trade Balance number in particular is quite important for our market as it impacts the Rand. Over the last year we've seen our trade deficit increase alarmingly and this has been one of the factors weakening our currency. If this trend continues, the R9/$ level will be breached sooner rather than later.

Until next, time that’s all from us.

Here’s to staying ahead of the game.

Warren Jeffery

Use this simple strategy to stay protected and profit in uncertain markets
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