What is Pairs Trading? The Financial Trading Strategy Explained

LONDON, August 25, 2011 /PRNewswire/ --

An increasing number of traders today opt for pairs trading when deciding their spread betting or CFD trading strategy. The concept centres around balance. Through pairs trading, a trader aims to create overall profit by taking two opposite spread betting positions on a pair of related stocks. Award-winning spread betting provider City Index (http://www.cityindex.co.uk/) explains pairs trading with this example:

Pairs trading example

Step 1: Selection

To engage in pairs trading, a trader first needs to find two stocks with a correlation; a strong tendency to move in line with each other on a day-to-day basis. For the purposes of the example, let us say that Bank A and Bank B represent a suitable pair.

Step 2: Value:

Next, the spread bettor needs to decide if one of the two stocks is under- or overvalued compared to the other. If the trader believes Bank A is undervalued compared to Bank B, they will go long (open a 'buying' position) on Bank A whilst simultaneously going short (taking an equivalent 'selling' position) on Bank B.

Step 3: Trade

These two opposing financial spread bets need be worth roughly the same amount. For example, if your position on Bank A is worth £2400 (300 price x £8 stake), your position on Bank B should be £2400 also (1200 price x £2 stake). The reason for this is that if the trades are not equal, the trader is merely reducing the risk of the larger trade rather than creating a situation in which they can profit from the pair regardless of whether the overall markets move higher or lower.

The Result:

If the overall market was now to move upwards, the trade on Bank A - the undervalued stock - would in theory close the gap and enter a profit greater than the loss incurred by the 'short' Bank B trade. Similarly, if the market was to dip, Bank A's stock would likely not fall as far as Bank B's stock, therefore putting the Bank B trade into a profit that outweighed the Bank A loss.

One way to get to know pairs trading is by using the City Index spread betting demo account to place a range of trade without risking your own money. Finally, whichever trading strategy you ultimately decide upon, always employ risk management including stop loss orders and sound money management.

Learn more about trading strategies with a free City Index trading seminar at http://www.cityindex.co.uk/learn-to-trade/

Spread betting and CFD trading are leveraged products which can result in losses greater than your initial deposit. Ensure you fully understand the risks.

About City Index

Today more and more individual traders are discovering the benefits of derivatives, and many of them are discovering them through a City Index trading platform.

As a group, we transact in excess of 1.5 million trades every month for individuals in over 50 countries worldwide. We provide access to a wide range of instruments including margined foreign exchange, CFDs and, in the UK, financial spread betting.

We constantly look to improve the performance of our platforms and expand our range of services. The result is that our customers benefit from innovative trading tools with transparent pricing, competitive spreads, and a high standard of customer support. Open your City Index spread betting account at http://www.cityindex.co.uk/spread-betting/start-spread-betting.aspx