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Contracts for Difference Pairs Trading

Pairs Trading
Written by Andy

Contracts for Difference – The Future of Trading

The concept of contracts for difference pairs trading is an extremely appealing one for traders. The idea is to identify two similar shares – usually from the same sector – whose prices generally move in tandem but that have temporarily diverged. Through buying the laggard and short selling the leader, the contracts for difference pairs trade can profit from the prices converging again.

The beauty of this strategy is that it doesn’t matter whether the market rises or falls, since the outcome of the trade simply relies on the relative movement of the two shares. Indeed many hedge funds rely purely on this technique to generate high absolute returns irrespective of the performance of the market.

When comparable stocks diverge, there’s a tidy profit to be had from speculating that they’ll converge again – however, there is a risk that such a movement is not just a blip.

An excellent low risk contracts for difference pairs trade for people new to the technique of cfd pairs trading involves the two different classes of Schroder PLC shares: SDR (voting) and SDRC (nonvoting). ‘Being different share classes of the same company makes this more akin to an arbitrage strategy. The non-voting stocks typically trade at a discount of 4% to 12% and when this widens it creates an ideal contracts for difference pairs trading opportunity. The key is to trade the illiquid non-voters first to make sure that this position is safely in place’.

The close correlation between the two share classes is evident from the chart and whenever the gap widens it is quickly closed down again, thereby creating the perfect scenario for a contracts for difference pairs trade.

CFD Pairs Trading is not for the Nervous

Giles Wilkes, who was head of the dealing desk at at a popoular CFD provider, ran a statistical simulation evaluating the whole principle of cfd pairs trading. ‘We used a computer program to identify pairs of highly correlated stocks that would diverge and then converge again. It was a good objective system but anyone looking to use it would need ice in their veins as they would typically be trading against the market, namely buying on bad news and selling on good’, said Wilkes.

It is a good system to use on panic days when stocks can get out of sync with each other, as essentially it is looking to exploit an overreaction.’

Wilkes identified a clear risk reduction benefit from the market neutral nature of the strategy and estimates the risk of a pair at 30% to 40% less than an equivalent uncovered position. He did, however, observe a clear risk return trade-off. ‘The longer a trader can keep the position the more chance he has of making money but it can be hard to keep faith with it. I would say that it is a good system to use on panic days when stocks can get out of sync with each other, as essentially it is looking to exploit an over-reaction.’ .

Manoj Ladwa a derivatives broker and technical analyst says that the extent of the risk reduction depends on the securities being traded. ‘Traders need to do their homework to spot these opportunities. For example, a long-short combination of BP and Shell will have a significant risk reduction effect, but BP and Premier Oil have a very low correlation so pairing them together will have virtually no impact.’

The Long and Short of It

In practice, the requirement to place both long and short trades means that anyone looking to implement this strategy will need either a CFD or a spread betting account. Less experienced traders will find it easier to open the latter.

Geoff Langham, head of trading at CMC, says that at CMC there is no real advantage either way.

‘With us, the only difference between the two is that any gains from spread betting are free of capital gains tax. Our prices are the same on both desks although with some of our competitors the spreads are bigger on spread bets than on CFDs.’

Some providers will also take into account the risk benefits of a pairs trade and will reduce the margin requirement for an active client who regularly makes this type of trade.

Perhaps the key point when placing a pairs trade is that the long and the short trades each need to equate to the same monetary exposure to achieve a market neutral position. For example, with the Schroder voting and non-voting shares trading at 650p and 601p respectively, a £10,000 position would mean shorting 1,538 SDR CFDs and buying 1,664 SDRC.

The same principle would also apply to spread bets, with the up bet and the down bet being for different amounts per point to reflect the unequal underlying prices. In this way the pairs trader can take the direction of the market out of the equation and simply speculate on the difference between the two share prices.

Matching the monetary values of the two trades has the added advantage that the pairs position can be monitored purely by the ratio of the two share prices. Any decrease in the ratio of the short price to the long price would mean that the combined position was in profit. One of the few brokers to let clients set targets and stops using this ratio is SFS International Securities.

Using stops is generally a very sensible precaution but Wilkes says that with pairs trading they can destroy the performance as in theory if someone trades on a divergence, any increase should represent a better trading opportunity. He says the answer is for traders to be rational with their capital and not trade too big too quickly.

CFD Pairs trading can take several different forms and Langham says that it doesn’t have to involve two shares. ‘We see three main types of pairs trades: two shares from the same sector, one sector versus another and one stock or sector versus an index.

‘The spreads are tighter on the sectors and indices – which can be important as you are making two trades – and the margin requirements are lower; our margin rates are 1% on sectors and indices and 5% on shares.’

Langham believes that the current conditions could make this the perfect market in which to trade a security against a sector or index: ‘Attention is very much on the US market where there are a lot of unanswered questions in terms of the shape of the economy, the oil price and the election result. There is a confused picture as to the direction the market will take, so for traders focused on a particular stock it can make sense to take out some of the market risk.’

A Tale of Two Indices

Some people like to trade one index against another – the Dow against the FTSE being a popular example. A number of the spread betting companies have responded to the interest by creating differentials that combine the two markets into a single bet, thereby reducing the costs and margin. For example, City Index quotes spreads for the differentials on the FTSE/Dow and the FTSE/DAX.

David Buik, an experienced analyst, cautions that pairs trades still carry significant risks. ‘Good information and timing is of the essence for this type of trade. One hears a lot of chat about these opportunities but wonders how much of it is valid. The danger is that although the position is market neutral, there is still a big exposure if both positions go wrong.’

The risk that Buik emphasises is highlighted by the recent performance of Tesco (TSCO) and M&S (MxS) (see figure B). The chart shows that these two securities produced ideal pairs trading opportunities in both July and August when their prices diverged before quickly converging again.

The problem is that anyone following this strategy in September who may have been tempted to short Tesco and long M&S looking for the historical pattern to reassert itself would have paid dearly for it. This is why doing the research is so important. With both companies scheduled to make trading announcements on September 22, the risks should have been seen to be too great. Indeed Ladwa suggests that the opposite trade would have been the one to make.

‘Tesco performed well in the run up to its results announcement, while M&S has under performed following the failed takeover approach by Philip Green. The combination of a long position in Tesco and a short position in MKS would have performed very well.’

Event risk such as this proves that despite the inherent market neutral nature of a pairs trade, it still isn’t safe for a trader to take larger positions than he normally would.

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