CFD Trading Strategies
Find out more about CFD strategies here
Pairs Trading
Pairs Trading is common in spread betting, warrants, and options, as well as CFDs. It is used when two competing stocks are both improperly valued, one overvalued and one undervalued. The CFD trader would purchase a long CFD on the undervalued company and a short CFD on the overvalued company. Once the market corrected the prices of the two companies, the CFD trader would profit on both bets.
For a pairs trade to work, the trader must ensure that he buys equal values of both shares. The profit/loss of pairs trading is calculated using a ratio. If this ratio increases when the CFD is closed, then a profit is made. If this ratio is less when the CFD is closed, then a loss is incurred.
Example:
Company X and Company Y, two competitors in the financial services sector, have prices of 980p and 490p respectively. A trader believes that Company Y’s shares will outperform Company X’s shares in the near future.
In order to profit from this correction, the trader purchases a buy CFD for 8,000 Company Y shares and a sell CFD for 4,000 Company X shares. Note that both contract values are £39,200.
The price ratio for this pairs trade is initially 490/980 = 0.5
* The ratio is the price of the buy over the price of the sell*
In two days, Company X is at 1,000p, and Company Y is priced art 515p.
The new price ratio is 515/1,000 = 0.515
Even though one of the bets was a loser, the overall result was a profit of £1,200 [( 8000 shares x (515-490)) + (4000 shares x (980-1,000))]
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