Pair trading is one of the most well-known Contract for Difference (CFD) hedging techniques. Find out more...
Profit regardless of which way the market moves
Pair trading is one of the most well-known Contract for Difference (CFD) hedging techniques.
Traditionally, you would either buy shares in expectation those shares will appreciate and sell shares in expectation those shares depreciate after you sell.
Pair trading involves playing off two stocks against each other and it doesn't matter which way the market moves provided that your pairs are related. Stocks of companies operating in the same sector tend to move in tandem, so if a sector performs well, most of the stocks of the companies within that sector tend to perform well too. Conversely, if a sector performs poorly, most of the stocks of the companies within that sector tend to perform poorly too.
Pair trading explained
By pair-trading, you are buying the CFD of the strongest stock within the sector while simultaneously selling the CFD of the weakest stock in the sector. If your strongest pair, predictably outperforms the weakest, you will profit regardless of which way the market moves -
the relationship between the pairs is the key to profit.
The idea is that you are effectively reducing your overall risk by giving yourself a second chance of making a profit even if the market moves against you.
The strongest stock in the pair is considered to be your
The weakest stock in the pair is considered to be your
The objective of this approach is to exploit a perceived future convergence or divergence in the underlying share prices of your selected CFD pairs. It is not necessary for each position to make a profit, rather only for the profit on one to exceed a potential loss on the other.
Upon executing the pair-trade you have selected, either the shares of both companies will move higher but your long position will make a larger move up than your short position, or the shares of both companies will move lower, but your short position will make a larger move down than your long position.
In both scenarios, you'll make a loss on one of your CFDs but count on making enough profit on the other CFD to offset your losses and provide a net gain.
Another scenario would be that both trades can move in your favour, allowing you to profit from the CFD you bought as the stock moves higher, while allowing you to profit from the CFD you sold as that stock moves lower.
On the downside, it's also possible that both trades can move against you, causing you to experience losses from both the CFDs you bought and sold.
Pair trading is best used when the market is volatile as it removes a degree of risk; it is a hedging technique.
Using CFDs to pair trade can amplify your gains as you buy control of the stocks using margin, never actually owning the underlying shares but profiting from their price movements. This is cost-effective and less risky than other investment techniques. Moreover, as it's an option most popular in the CFD market, you're able to pair-trade indices and commodities too.
Pair trades tend to be longer-term in nature and can result in double commissions being paid to your CFD provider since this strategy involves trading two positions. Risk management tools are important to employ such as placing a stop loss during the pair-trade, mitigating unwanted losses.
Also be watchful of unforeseen market events such as unexpected company announcements, profit warnings or takeover bids, for example, all of which can have an unfavourable effect on your pair trade. It is wise to have a point of exit, either as a set percentage or a set deposit amount, before entering the pair trade CFD.
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