Pairs Trading with CFDs

With CFDs it is also possible to execute more advanced trading strategies like pairs trading. Pairs trading involves exploiting the difference in value between two historically related assets in the same sector and you can also utilise this as a kind of hedging strategy.

Pairs trading (sometimes known as statistical arbitrage, or a market neutral strategy) is a trading strategy that has become popular since the advent of CFDs (about 20 years ago), prior to this it was hard for a trader to short sell. Pairs trading is the action of an investor buying into one instrument and simultaneously selling another - it is called pairs trading because you are in effect trading a pair of CFDs. Thus, pairs trading involves taking a long and short position simultaneously in two related shares in the same industry. When you apply this trading strategy to CFDs you get the advantage of the leverage that CFDs provide you, so that your gains can be significant compared with your outlay - yet, you are still indifferent to the general market direction since it doesn't matter which way the market moves as long as you pick a strong pair of associated shares or other instruments. Most traders tend to utilise a pairs trading strategy when there is uncertainty as to the direction of the market as this strategy eliminates market risk.

The strategy is simple and low risk as it is market neutral. As two stocks are played against each other; risk is limited. Profitability is based on stock selection and not overall market movements. Often opportunities to pair two shares together happen when a divergence in price of similar shares in the same sector arises. The stocks of companies operating in the same industry tend to move in tandem so, if an industry performs well, most of the stocks of the companies within that industry tend to do well too. Of course, the converse holds equally true. The key to pairs trading is to identify two financial investments that are closely correlated in the way they move, and that have drifted away from their usual relationship. You can buy one and short the other, profiting when they come back into the usual relationship. In other words, here you are speculating on the relative difference of the two shares rather than their real performance.

Using contracts for difference allows you to multiply your gains, as you buy control of the securities using margin, never actually owning the shares but profiting from their price movements. As the investments are correlated, if something moves the markets in general or the sector they are in to increase or decrease in value, it does not matter, as both stocks will move up or down together. This means you do not have to anticipate the general market fluctuations, as they are cancelled out. You are just trading on the relative differences. It really is as simple as that.

 

The examples of appropriate trading pairs usually given are Rio Tinto against BHP Billiton, Coca-Cola and Pepsi-Cola, Stockland against Mirvac, or Dell Computer and Hewlett Packard. These would normally be expected to track closely to each other, and pairs trading will identify any differences that should be temporary and would be expected to come back into line in due course. Finding a good couple of candidates is the key to making the strategy work in all markets, and it's easiest to pick them by commonsense, then check the charts by eye to see if they really are similar. You should first review the different sectors, and then the equities within those sectors, and you will be able to see which are interrelated. Pairs traders tends to pick two shares that move in a similar way, have similar business models and are likely to be affected similarly by market events. Typically they would be in the same sector.

Examples -:

  • Buy GlaxoSmithKline, Sell AstraZeneca
  • Buy Pepsi-Cola, Sell Coca-Cola
  • Buy Mirvac, Sell Stockland
  • Buy Hewlett Packard, Sell Dell
  • Buy Barclays, Sell LLoyds
  • Buy Rio Tinto, Sell BHP Billiton
  • Buy National Australia Bank, Sell Commonwealth Bank.
As a pairs trader, you buy a contract for difference on the stock of the strongest company within the industry sector and sell a CFD on the stock of the weakest company within the industry. Once you have entered your pairs trade, a number of scenarios are possible:
  • Both shares rise but the share underlying the CFD you bought gains more than the share underlying the CFD you sold (good).
  • Both shares fall but the share underlying the CFD you sold falls more than the share underlying the CFD you bought (good).
  • The share CFD which you bought rises while the share CFD which you sold falls - allowing your to profit from both trades (best scenario!).
  • The share CFD which you bought falls while the share CFD which you sold rises - resulting in a loss on both trades (not nice!).

Although pairs trading is a relatively low risk strategy it is still possible for stock specific factors to cause the divergence to widen resulting in losses on both trading positions. Traders should maintain stop loss orders on both positions in case the stocks drift apart rather than come together.

Pairs Trading Example

For example, suppose you believe that GlaxoSmithKline is undervalued compared to AstraZeneca (both companies operate in the Pharmaceutical industry). GlaxoSmithKline (LSE:GSK) trades at £12.21 while AstraZeneca (LSE: AZN) is currently trading at £32.28. With a pairs trade you enter a long CFD position on GlaxoSmithKline and a short position on AstraZeneca. It is important that you balance your trades by ensuring that you control the same amount of value in both shares, as otherwise the pairs trading strategy will not work as expected. Assuming that you wish to control about £100,000 worth - or about 3098 of AstraZeneca shares at £32.28 each (3098 x £32.28 = £100,003.4) - and about £100,000 worth - or about 8190 GlaxoSmithKline shares at £12.21 (8190 x £12.21 = approximately £100,000).

Now, you can enter your trades. Since CFDs are a leveraged-traded product, you can control the £100,000 exposure of the underlying shares without having to put in £100,000 of your own monies. Let's assume that you only have to deposit 5% of the value of AstraZeneca (5% of £100,003.4 = £5000) and 10% of the value of your GlaxoSmithKline positions (10% of £100,000 = £10.000). So in total you have to deposit £15,000 as margin to open the two CFD trades, as opposed to the full £200,000 if you were to buy the shares directly.

Now, let's assume that in the next few days the price of GlaxoSmithKline's shares rises sharply from £12.21 to £13.14 while the stock price of AstraZeneca retraces from £32.28 to £32 and you exit your pairs trade -:

Your profit on the GlaxoSmithKline long position is £0.93 per CFD, or £7,616.7 (8190 0.93 = £7616.7).
Your profit on the AstraZeneca short position is £0.28 per CFD, or £867.44 (3098 0.28 = £867.44).
Your total profit on this pairs trade CFD is therefore 8,484.14 (£7,616.7 + £867.44 = £8,484.14).

Keep in mind that you pay (on long positions) or receive financing (on short positions) interest every day when you trade CFDs on margin. These payments and credits will help to offset each other in a pairs trade.

Is the Pairs Trading Strategy Profitable?

Two Australian researchers have examined the impact of profitability of pairs trading in the US equity market over the period 1963-2009. After controlling for commissions, market impact and short selling fees; they find that pairs trading remains profitable, albeit at much more modest levels.

Specifically, they document a risk-adjusted return of about 30 bps per month amongst portfolios of well matched pairs that are formed within refined industry groups. Strategies that are implemented on the top 30% largest stocks produce an average alpha of 19 bps per month. The authors conclude that pairs trading exhibits a lower risk and lower return profile than a short-term contrarian strategy that sorts stocks relative to their industry peers.

Another study has investigated the profitability of a selffinancing pairs portfolio trading strategy in the Finnish stock market under different weighting structures. Over the period 1987 to 2004, they find pairs trading to be profitable even after allowing for a one day delay in the trade initiation after the signal. On average, the annualized return can be as high as 15%. The authors say the profits are not related to market risk and a fully invested pairs trading strategy is found to produce positive alpha during the sample period.

Do, Binh Huu and Faff, Robert W., Are Pairs Trading Profits Robust to Trading Costs? (November 5, 2010).
Broussard, John Paul and Vaihekoski, Mika, Profitability of Pairs Trading Strategy in Finland (December 21, 2010).


Researching Pairs Trading Opportunities

There are two ways to see how the prices usually track each other, and hence see if they are out of line. Quite simply, you can look at the price of one minus the price of the other over time, and see how much it usually is, from which you can see if there is a trading opportunity at the moment. You will find many charting platforms allow you to superimpose the two charts of the securities to compare them. This method works best when the prices are similar. Note that since pairs trades involve two positions, they incur two sets of transaction costs.

A pairs trader looks for a divergence in the share prices and then trades on the expectation that the stocks will revert back to their normal relationship.

The alternative way of researching the possibilities is by using a facility you may have on your charting platform. With some charting software you can create a price ratio chart, which divides one price by the other so you can see any divergence from the normal. The line on price ratio chart will center around a particular value, and any divergence above or below the value can be traded. You want to take a long CFD for the share expected to rise, and a short CFD position for the security which must fall to bring the relationship back into line.

Pairs trading is not only limited in scope to trading share CFDs either. It is becoming very popular for use with indices where investors take the expectation that one index will outperform the other. An example of this may be the USA market compared to the Australian market (say buying an ASX 200 index CFD while selling an S&P 500 index CFD with the belief that the Australian market will outperform the USA market).

You can also pair commodities such as gold-silver, crude oil-gold, lead-zinc and copper-silver. For instance, the gold-silver ratio is essentially the quantity of silver that one can buy with one ounce of gold. Presently, the gold-silver ratio is trading at a yearly low of 1:36.83, a clue that silver has risen much faster than gold. In early August, it was as high as 1:70.88. Most pairs traders would say that the ratio readings mean that either silver is prone to a downward price correction or gold should rise as this level is not sustainable and hence traders would sell silver and buy gold in this ratio.

Another strategy is to use sector CFDs in which case you might couple the health care sector versus the materials sector or say, the energy sector versus the ASX 200 index (you would buy the energy sector and short the ASX 200 index if you believe the energy sector to be undervalued relative to the market). When choosing sectors you should also consider their weighting within the overall market index as this will assist you to decide the sectors' correlation to the overall market.

Pairs trades are simple to construct and also relatively inexpensive. The offsetting positions reduce overnight financing fees as the short position generates revenue that can be used to cover the cost of the long. To reduce costs and mitigate risk it is important that the position size for each trade is hedged and matched equally.

 ...Continues here - Explaining the Long-Short Trade

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