Contracts for difference

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13. Strategies: Pairs trading

In the examples we've looked at so far, the trades have all been 'directional' plays on the share price of a single stock. In other words, they aimed to capitalise on an anticipated rise in a stock price by buying a long CFD or on an anticipated fall by going short.

When markets are extremely volatile, however, directional speculation can be difficult. A stock may rise exactly as you expect it to for a period and then, for no apparent reason, drop sharply back. If you don't close out at the right moment, you fail to make a profit.

It's partly in response to the limitations of directional trading that pairs trading has developed. Essentially, you're interested in how two stock prices move relative to each other, rather than in the movement of one price alone or in the movement of the market as a whole.

Provided you are correct about the comparative performance of your pair of stocks, you will make money whatever they do individually and whatever the market as a whole is doing.

»  Example

• You think that Sainsbury (trading at 400p) is going to outperform Tesco (trading at 250p) over the next month.
• You buy 10,000 Sainsbury CFDs at 400p, equivalent to a contract value of £40,000.
• You sell 16,000 Tesco CFDs at 250p, equivalent to a contract value of £40,000.

With these two positions, there are several outcomes:

1. The shares both move up or both move down by the same percentage, in which case the gain on one is cancelled out by the loss on the other, e.g. they both rise 10%.
   - You sell Sainsbury at 440p and make £4,000 profit
   - You buy Tesco at 275p and make a £4,000 loss
2. Tesco outperforms Sainsbury, in which case you would make a net loss, e.g. Tesco rises 10%, Sainsbury rises 5%.
   - You sell Sainsbury at 420p and make £2,000 profit
   - You buy Tesco at 275p and make a £4,000 loss
3. Sainsbury outperforms Tesco, in which case you would make a net profit, e.g. Tesco drops 10%, Sainsbury rises 10%.
   - You sell Sainsbury at 440p and make £4,000 profit
   - You buy Tesco at 225p and make an £8,000 profit

1. What are CFDs? 2. The benefits of CFDs 3. Initial margin 4. Variation margin 5. Commission costs 6. Interest payments 7. Dividends 8. Example of a long and short trade 9. Comparison of CFDs to share investing 10. Comparison of CFD trading to spread betting 11. Types of order 12. Stop losses 13. Strategies: Pairs trading 14. Strategies: Hedging an equity portfolio 15. Opening an account with a broker 16. Conclusion

• Single Stock Futures: The Complete Guide