For CFD users, pairs trading is a standard strategy that lets you ignore the current trend in the overall market, or even in a stock. You make money if your favoured stock – the one you buy – outperforms another similar one that you sell. But there are traps, including the need for close monitoring.

Financial markets globally, like Japan itself, are awash with tsunami overload. Most stocks in the Australian market are falling because of uncertainty, but could rebound at any moment if political trouble clears, the worst-feared disaster does not eventuate, or if the global economy improves.

Short selling, the obvious strategy to adopt when markets are falling, is riskier than usual right now. Equity market volatility is up, which means prices are being driven by emotion and speculative trades, and that in turn means a mere change in sentiment can overshadow the effects of fundamental influences. It also means markets are over-reacting.

In such an environment, prices could go either way. Even selling a broad range of stocks, in the hope that diversification reduces risk, could result in most of the trades being stopped out – that is, reaching the price where an exit is required to prevent further losses.

An alternative to taking positions in stocks is to use a strategy that pairs two similar stocks – or commodities for that matter – together because they have a high correlation, and tend to move in the same direction. Buying one and selling the other removes market risk – it doesn’t matter whether both stocks go up or they both go down -- and leaves only the relative price of the two as the underlying risk.

It’s important that the two stocks or instruments be closely correlated because pairs trading is an arbitrage strategy – that is, it attempts to take advantage of prices that are misaligned. Prices of shares in banks, for example, tend to move in tandem because they are affected by the same factors. If one suddenly starts lagging or leading the others in price change, the assumption is that this is probably a temporary aberration and that the prices will come back into line. As they do, a profit opportunity exists.

Alternatively, a fundamental affecting one bank stock – perhaps a bank has success in an overseas market, or another suddenly has trouble with a large client default -- may cause an unusual price move in that bank’s stock compared to another typical stock in that sector.

The pairs trade is designed to profit from such a situation. In one case you buy the bank stock expected to do well, and sell another in equal dollar amounts. In the other case, you sell the bank expected to underperform and buy shares in another.

“Traditionally a pairs trade is between two instruments in the same asset class -- not Woolworths and Rio,” for example, says Chris Weston, Analyst at IG Markets. This is because trading widely uncorrelated stocks can give wildly unpredictable results. “You really want to play the same thematic.”

If you do think Rio will outperform Woolworths, they are best taken as separate trades, each on its own merits.

“Say BHP reports good earnings and a big share buyback, while Rio announces worse than expected earnings,” Weston says. “Then you would buy BHP over Rio. If iron ore prices go into freefall, for example, and tank, you would expect Rio to underperform because it gets 90 per cent of its earnings from iron and copper – it’s less diversified and more risky than BHP.” (See example).

“Fortescue and other high-beta (comparatively more volatile) miners tend to outperform the big miners when markets are running up,” Weston says. You can also trade Woolworths against Wesfarmers, or media stocks against each other. “It’s most important to match your exposure dollar amounts -- the total equity exposure should be the same in each stock.”

It’s also possible to trade one sector of the market against another if your provider offers CFDs over sector indices, Weston says. “After the recent world disasters we are now seeing people trading on emotions rather than on fundamentals, and in that situation a clear trade is to sell materials and buy consumer staples or telecommunications companies or health-care stocks,” Weston suggests.

“The airlines are also interesting. Looking at valuation, Qantas seems very cheap; you can buy at seven times forward earnings and it has a price to book of 70c in the dollar,” Weston says -- in other words, it is trading at less than its net asset value.

Although negative news has badly affected Qantas recently, it reported a better result than its competitor, Virgin Blue, suggesting a pairs trade – buy Qantas and sell Virgin Blue.

Although pairs trading is a simple concept, it presents some challenges in execution, including the fact that you can’t place automated stop-loss orders, making it more difficult to manage risk, points out David Land, market analyst at sharebroker and CFD provider CMC Markets.

“You expect that in a large number of pairs trades you will lose on one leg, but you can’t, say, close just one leg because then market risk is back into equation,” he says.

“What you can do is have a manual stop-loss on the ratio between the two prices,” Land says. “The pair has to be looked at as a single trade.”

He says, “Traders need to be able to measure what is a reasonable spread between the two stocks. It can be hard to say whether there is enough of a spread [movement away from the expected price ratio]. Some say, do it visually, but if you measure it based on standard deviations you get a much better idea as to how far the spread has gone and how likely it is to be a turning point.”

Standard deviation is a statistical calculation giving the average move away from the norm, and can be calculated in a spreadsheet, Land says. It’s used to help identify when one of the pair has got out of alignment (entry point) and when it is back in line (exit point).

“People expect a larger position size with a pair because they have netted out market risk, but that’s not a license to go nuts. If you typically risk 1 per cent you may risk a little more on a pairs trade. Just because the trade is market neutral it doesn’t mean there’s always less risk. For example, If company A launches a takeover bid for company B and you are long in the predator stock and short the target, you can lose badly on both trades,” he says.

But it does protect a trade from a sudden move in either direction in the overall market that affects all or most stocks. “The payoff per trade will be lower than in a ordinary long or short trade, but you need to look at the risk associated with the worst case,” Land says.

“The position needs constant monitoring, but you can see what the probable downside would be if the trade is expressed as a ratio. You should still do risk-reward analysis; risk and reward would both shrink. Also, remember that the scenario you expect may take some time to unfold.”

He suggests this is likely to be weeks or months rather than days, and brings up the point that a pairs trade does involve a cost of carry – the net interest paid on the trade (see example). The longer the trade stays in place, the more the interest erodes its profitability.

It is also possible to use pairs trading to trade quite temporary blips in price ratios, in which case you need to be nimble enough to catch the moves in each direction.

Outside the sharemarket, pairs trading can also be implemented on commodities that track each other closely, such as gold and silver, or one grain against another. Since all pairs trades tend to be longer term that outright trades, fundamental analysis tends to need more weight than it would normally be given, especially in seasonal commodities like grains and energy commodities.

Pairs Trade Example: BHP Billiton (BHP) versus Rio Tinto (RIO)

Price of BHP (right hand side) vs RIO (left hand side) August 2010 to March 2011. Source: Australian Securities Exchange (ASX)

Example: On 17 March 2011, BHP Billiton is trading at $43.40 a share on the ASX while Rio Tinto is priced at $78.50, a ratio of about 1.8:1. You believe that, because it is more diversified, BHP is likely to outperform Rio over the next weeks or months, which will tend to push BHP’s relative price higher.

A relatively higher price for BHP would reduce the ratio of BHP shares to those of Rio from 1.8:1 to something less. The ratio doesn’t have to move far to give a profit, but a move below 1.8:1 is unusual for the pair – in fact, over the past year the ratio has tended to move above this  before pulling back. The trade depends on fundamentals in BHP’s favour, such as the fact that it is less dependent on iron ore than Rio Tinto, and on investor perception agreeing with this analysis.

The strategy involves buying and selling equal dollar amounts of BHP and Rio shares respectively, so for example based on an allocation of $10,000 to the trade – involving margins of some $500 at leverage of 20:1 – we buy $5000 worth of CFDs over BHP shares at $43.40, giving us 115 shares, and sell $5000 worth of CFDs over Rio, giving us a sold position over 63 shares. The margin on each of the two legs of the trade will be approximately $250.

Scenario 1

If, after some time, BHP’s price moves up to $48.00 while Rio remains comparatively slow-moving in the upward direction and reaches only $81.60, the ratio will have fallen from 1.8:1 to 1.7:1. Our profit will be

Buy 115 BHP shares at         $43.40        $4991

Sell 115 BHP shares at          $48.00       $5520

Profit before costs                                   $529

Sell 63 Rio shares at             $78.50        $4945

Buy 63 Rio shares at             $81.60        $5141

Loss before costs                                     $196 -

Net profit                                                 529

                                                              196-

                                                              $333

This represents a profit of 67 per cent compared to the initial outlay of $500. Costs of the trade will be a minimum commission of, say $15 on each bur or sell trade, amounting to $60, a minimum buy-sell spread on the share prices of perhaps 1c a share, a negligible amount, and net interest, which over a month would amount to $5000 x 6.75%/12, or $28, paid for the long side, less $5000 x 2.75%/12 or $12 received for the short position, a net $16. Interest is based on the RBA cash rate of 4.75 per cent per annum, plus 2 per cent for longs and less 2 per cent for shorts. The interest margin, kept by the CFD provider, is typically 2 per cent but may vary, as may minimum commissions. The deduction of costs reduces the net profit to $285, a gain of 57 per cent.

Profit                                                      $333

Commission ($15 per trade x 4)                   60-

Spreads                                                       2-

Net interest                                               16-        

Net profit after costs                                 $255

Scenario 2

Of course, the ratio may move in the other direction. BHP may retreat as oil prices continue falling, for example, in which case the trade may move against us. If Rio takes off and reaches $85, for example, while BHP moves up sluggishly to just $44.70, the ratio will have moved to 1.9:1 and when we unwind, our net loss before costs will be $261 – we lose more on Rio than we gain on BHP.

Since we don’t want losses to be so large compared with prospective gains, we may decide to quit the trade when the ratio moves to 1.85:1. This would involve keeping daily watch in ratio changes and exiting from both trades at once. It’s inadvisable to exit from just one leg and leave the other unless the remaining trade is one you would have entered anyway based on your criteria.

Worst-case scenario

We can discount the unlikely event of a win on both legs for the purpose of analysis. If it does happen, it’s a bonus. A pairs trade tends to reduce risk, but in a low percentage of cases both legs will lose money, for example if BHP falls while Rio rises in price at the same time. This does have to be taken into account when entering the trade. Close monitoring is needed to prevent any such twin losses from mounting by keeping watch on the price differential between the two shares, and quitting if losses rise above your predetermined acceptable level for the trade.

Other articles in this week's newsletter

The CFD Strategy The Professionals Use

18 Share Tips - 28 March 2011

Outlook For Gold Stocks

Top 4 Fibonacci Retracement Mistakes To Avoid

Using Porter's 5 Forces To Analyse Stocks

The Value Investor's Handbook

Demographic-Trends And The Implications For Investment