CFDs have been accessible on the stock sector for the last 22 years and provide a broad variety of investment options. You can utilize them to take a long position, or a short position, or you can mix a long and a short position to build what is known as a pair trade. Pair trading means holding a long and short position concurrently in two associated shares.
Pairs trading has been found to provide consistently good outcomes. Contracts for difference are very useful for this form of trading as they encourage shorting, do not incur stamp duty and may be traded on a margin basis.
Pairs Trading Explained
Pairs trading was first launched in the mid-80s by Morgan Stanley’s consortium of professional analysts. The definition incorporates statistical and methodological analysis to define future market-neutral income. A pairs trade is a market technique that entails pairing a short position with a long position in two highly correlated stocks.
The peer CFD trading approach is focused on the historical association between two stocks. Pair trading shares must have a strong favorable correlation, which is the main factor of the strategy’s earnings. Pair trading policy in CFDs is often applied when an investor detects a gap with the correlation.
If trading pairs differ, the buyer will try to take a dollar equivalent to the long place of the poorly performing security and sell short of the outperforming security. When the shares revert to their historical correlation, the price convergence may result in a profit.
Advantages of Pair Trades
There is no direction risk in pair trading. Direction risk implies the danger involved with price fluctuations due to a shift in business direction. For example, a short position is subjected to the risk that the price of stocks may increase. But in trading pairs, the benefit relies on the price change differences between two stocks which are in pairs, and not in the path in which they move.
You can also incur profit in different market directions with limited risks. The idea of this technique focuses around balancing a long position with a short position of linked securities, which effectively provides a buffer. Thus, the risk is still restricted and regulated. It’s important aspect is that buyers will make a profit through it, irrespective of market circumstances.
Limitations of Pair Trades
There are also some drawbacks in pair trading. One being that the exchange in pairs depends on a strong statistical association between two securities. Many pair trades would need a 0.80 connection, which may be challenging to define. Second, although historical averages may be reliable, past values are not necessarily representative of potential future trends.
Finding Pair Trading Opportunities
The best approach to discover the possibilities is to utilize the tool that you may have on your charting platform. Using any charting tools, you can build a price ratio chart that separates one price from the other so that you can identify some deviation from the standard. The line on the market ratio map should be focused on a specific price, so any deviation beyond or less than the amount can be traded.