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. 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 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. 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.
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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.
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.
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). 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.
