Spread Bet Uses - Pairs Trading

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Spread Bet Uses - Pairs Trading
by LearnMoney.co.UK

What Is Pairs Trading?

Pairs trading using spread bets is simply two transactions where one share is bought and another share, usually in the same sector, is sold short. An example of a spread bet pairs trade would be buying Vodafone and selling short MMO2, buying Ford and selling short General Motors, or buying Glaxo Welcome and selling short AstraZeneca.

The spread bet trader who utilises a pairs trading strategy is simply speculating that one share will out-perform the other, in both an up or down stockmarket. A Pairs trade is therefore not a bet on the overall stockmarket direction.

Balancing the Two Sides

* If Vodafone is trading at £1.20 and MMO2 is trading at £0.60 then buying £5 of Vodafone and selling short £5 of MMO2 would be an unbalanced trade
* The direction of the overall market would not be totally nullified
* If the overall market slumped and both stocks fell 15% the spread bet trader would lose money because he was in effect only half-short MMO2

So the ratio of each side is very important if you don’t want to put an overall bullish/bearish trade on. To get the two sides balanced is very simple, just divide one into the other. So in the Vodafone case you should trade £1 for every £2 short in MMO2.

Some pairs traders like to get technical and perhaps work out the volatility or beta on each stock, and then marry up the two sides by this methodology. The beta of a stock is how much it should move for a given move in the FTSE 100. If the FTSE 100 moves up 1% then ABC stock with a beta of 2 is expected to move 2% higher, while XYZ stock with a beta of 0.5 would be expected to move only 0.5% higher.

An Example of a Pairs Trade - IBM v Microsoft

microsoft_ibm_spread_chart.JPG

* The chart above shows IBM's price minus Microsoft's and also takes into account the ratio of the two stock prices as they are not the same
* Both stocks have risen since the October 2002 lows but the chart shows that IBM's stock price has been out-performing Microsoft's
* A spread better would therefore have made money buying IBM and selling short MSFT as a pairs trade

Another Example of a Pairs Trade - Nasdaq 100 v S&P 500 Index

qqq_spy_spread_chart.JPG

* This is a chart showing the Nasdaq 100 versus the S&P 500 index, using their tracking stocks QQQ and SPY
* Anyone who had bet that the Nasdaq would have out-performed the broader S&P 500 index anytime since the October 2002 lows would have generated excellent tax-free profits

A Pairs Trade is NOT a bullish/bearish trade on the market

A pairs trader using spread bets is really trying to take the overall direction of the underlying market out of the equation and just speculate on the difference between the two share prices.

Skewing the Pairs Trade To Add Direction

Some spread betters like to construct their pairs trades so that they have a bullish or bearish overall market slant.

* In the Vodafone/MMO2 example if you were slightly bullish towards the overall FTSE 100 you could have bought £5 of the Vodafone and sold short £7.50 MMO2 instead of £10 a point
* If the market were to rally then this trade would likely make more money (than if done is a strict ratio) because you'd obviously lose less on the short MMO2
* But if the overall market were to fall then the trade would likely not make as much as if the two sides were perfectly balanced

Short Term Trading a Pairs Strategy Can Be Expensive

Watch the cost of doing business with pairs trading because you’ll be paying away two bid-offer spreads. For day trading they're normally not recommended. Pairs trading is better suited to when you have a view over a week or two, perhaps even longer.

Volatile Markets work well for pair strategies

Everyday pairs trading is often not the way to go because relationships between stocks in the short term can be somewhat fickle. One of the best times to get involved with Pairs is when the markets get volatile and you spot some clear imbalances between stocks within the same sector, or even against the index itself which is discussed below.

Shares Versus Index

* Another way to pairs trade using spread bets is to trade a stock against the underlying index
* For example, buy Barclays and sell short the underlying FTSE 100 spread bet, on the assumption that whatever way the FTSE moves, Barclays share price is likely to outperform
* As ever you have to make sure you get the weightings. of each side correct and you'd do this by a simple percentage analysis
* What is a 1% move in Barclays worth in points versus a 1% move in the FTSE 100?

When To Get Involved In Pairs Trading

When the markets get volatile and certain shares or sectors are sold off heavily then it can be lucrative to trade shares or even sector spread bets against the underlying stock index. With hindsight back in September 2002 when the UK insurance sector was sold heavily would have been an opportune time to buy insurance shares and sell short the FTSE 100. This would have been on the assumption that insurance stocks were very oversold against the overall market.

Advice for Beginning Traders & Pairs Trading

* Pairs trading using spread bets can be very lucrative but can be highly technical
* Traders should only try it when they've got some good experience in trading and spread bets in general
* It is also good advice when you're starting out trading a new strategy to bet in small amounts at first. A spread bet broker like Finspreads offers small betting stakes
* The market and opportune pair trading strategies will always be there