PICKING out individual stocks from a sector can be a tricky business. Even if you think that a particular equity is ripe for the picking, it could be dragged down by a fall in the sector as a whole. This is where pairs trading can come in to help you. “Pairs trading is an often overlooked strategy in favour of taking one-way directional bets,” says Manoj Ladwa, senior trader at ETX Capital. “Pairs trading allows the trader to hedge and reduce risk by going short and taking out a trade in the opposite direction.” He points to a strategy of going long on Shire Pharma and short AstraZeneca – both competing in the same sector but with differing fortunes over the last month (see charts, below.) Should the pharma sector take a tumble, you would be hedged against the fall – the thing that would matter would be the relative performance of Shire Pharma against AstraZeneca. Similarly, you can also take a position on two equities from two different sectors – one cyclical and one anti-cyclical – again relying on their relative performance.
PAIR PICKING PROBLEMS
When it comes to pairs trading with spread betting, there are a couple of things to be careful of. Ian O’Sullivan, head of sales for SpreadCo, points out you might have to hold a position for days, if not weeks, for the spread to come back in to line and allow you to trade out – this can lead to expensive financing costs to hold the position open. As such you should look to whether your spread bet provider charges you to be short overnight – if not, you only need to pay the financing on the long side of the pairs trade. According to O’Sullivan, you should also look to avoid getting stopped out on one side if things move rapidly, but not being able to close the other side of the trade on time or at a price that means you actually make a profit on the trade. “Of course the other problem you could face is a sudden event such as a takeover announcement, profits warning, senior executives leaving for a rival which can blow even the most carefully planned pairs trade out of the water,” says O’Sullivan. “But if you can watch for opportunities and get in and get out when the time is right, pairs trading can be a nice little earner with reduced risk compared to taking an outright position on one side or the other.”
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