e-Book: Hedging with CFDs – Part 3 – Pairs Trading

Another popular hedging strategy involves buying a company’s CFD and simultaneously selling a rival company’s CFD. This is called pairs trading because you trade a pair of CFDs. The shares of companies in the same industry tend to move in the same direction so, if the industry performs well, most of the shares of the companies within that industry tend to do well too. Of course, the converse is equally true.

As a pairs trader, you buy a CFD on the share of the strongest company within the industry and sell a CFD on the share of the weakest company within the industry. Once you have entered your pairs trade, you anticipate that one of two things will happen:

In both scenarios, you hope to lose money on one of your CFDs and expect to make sufficient on the other CFD to offset your losses and leave a net gain. It is like making a prediction that, if a new Porsche raced a 1961 Volkswagen Beetle, the new Porsche would win. Of course the new Porsche might get a flat tyre or hit a wall before it finished the race, allowing the Beetle to win, but the chances of that happening are slim and the odds are in favour of the Porsche.

Both trades could conceivably move in your favour – allowing you to profit from both the CFD you bought as its underlying security moves higher and from the CFD you sold as its underlying security moves lower.

Conversely, it is also possible that both trades could move against you. You could lose on the CFD you bought as its underlying security moves lower, and likewise lose on the CFD you sold as its underlying security moves higher.

Imagine you wish to pair trade on shares in the Resource Sector industry, and you think BHP Billiton and RIO Tinto make great candidates for a pairs trade. BHP trades at $27.00 whilst RIO trades at $75.00.

It is crucial you balance your trade, otherwise it may not perform the way you expect it to. So ensure you control the same amount of value in the assets on which the CFDs are based. In this case you want to control approximately $100,000 worth – or 3,703 shares at $27.00 per share (3,703 × $27.00 = $99,981) – of RIO Tinto shares and approximately $100,000 worth – or 1,333 shares at $75.00 (1,333 × $75.00 = $99,975) – of RIO Tinto shares.

Once you know how many CFDs you wish to purchase, and the current price, you can enter your trade. Because you are trading CFDs, you are only required to deposit a portion of the total value of the position as margin for the trade. As the margin requirement for BHP is 3% and 10% for RIO you only have to outlay 3% of the value of BHP’s share price, or $2,999 ($99,981 × 3% = $2,999) and 10 %t of RIO Tinto’s share price, or $9,997.50 ($99,975 × 10% = $9,997.50). This means that in total you provide approximately $13,000 in margin to enter this trade with CFDs, not the full $200,000 require if you were to open the share positions.

Remember that you pay, or receive, interest on a CFD position held overnight. In the above example you pay interest of $21.91 per day on the BHP Billiton CFDs you have bought, yet simultaneously receive interest of $10.96 per day on the RIO Tinto CFDs you have sold.

Now imagine that the price of BHP rises slightly to $27.40 and the price of RIO Tinto falls to $74.75 over the next fortnight, and you exit your trade. Your profit on the BHP position is $0.40 per CFD, or $1,481.20 (3,703 × $0.40 = $1,481.20). Your profit on the RIO Tinto position is $0.75 per CFD, or $999.75 (1,333× $0.75 = $999.75). Your total profit on this pair trade is therefore $2,480.95 ($1,481.20+ $999.75 = $2,480.95).

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