Why Pairs Trading Might be the Spread Betting Strategy for you

LONDON, September 29, 2010 /PRNewswire-FirstCall/ -- When it comes to spread betting strategies ( http://www.cityindex.co.uk/spread-betting/), many traders today opt for pairs trading. As a concept it is simple; the idea is to make overall profit from two opposite spread betting positions on a pair of related stocks.

Example of pairs trading in spread betting

Imagine that a spread bettor specialises in the financial sector. To engage in pairs trading, that spread bettor would need 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 relationship like this and are therefore a suitable pair.

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

These two opposing financial spread bets need be worth roughly the same amount, for example Bank A: 300 price x GBP8 stake = GBP2400, Bank B: 1200 price x GBP2 stake = GBP2400. The reason for this is that if they are not, then the spread bettor 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.

If the overall market was now to move upwards, the Bank A spread bet (http://www.cityindex.co.uk/spread-betting/how-to-spread-bet.aspx) - the undervalued stock - would in theory close the gap and enter a profit greater than the loss incurred by the 'short' Bank B spread bet. Similarly, if the market was to dip, Bank A's stock would presumably not dip as far as Bank B's stock, therefore putting the Bank B spread bet into a profit that outweighed the Bank A loss.

In this respect, pairs trading is similar to hedging in financial spread betting, as it can create an equilibrium where one half of the pair becomes profitable when the other half loses money. It also follows the same principle as Forex trading, where every spread bet you make is actually two spread bets - in the case of a GBP/$ trade, one bet would go long on Sterling whilst one would go short on the Dollar.

One good way to get to know pairs trading is by using a spread betting demo account (http://www.cityindex.co.uk/learn-to-trade/demo-account.aspx) to place a range of spread bets without risking your own money. As with all spread betting strategies, the overall goal of pairs trading is to make profits that exceed your losses. If you can find a spread betting strategy that does that for your trading, the only thing that you need to do is stick to it.

Spread betting and CFD trading are leveraged products which can result in losses greater than your initial deposit. Ensure you fully understand the risks. To learn more about spread betting, visit http://www.cityindex.co.uk/spread-betting/

Disclaimer: Spread betting and CFD trading are leveraged products which can result in losses greater than your initial deposit. Ensure you fully understand the risks. Spread betting and CFD trading are exempt from UK stamp duty. Spread betting is also exempt from UK Capital Gains Tax. However, tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.

Contact: Joshua Raymond, City Index Group, Tel: +44(0)20-7107-7002, Email: joshua.raymond[at]cityindex.co.uk, Jonathan Smith / Alex Nekrassov, New Century Media, Tel: +44(0)20-7930-8033, Email: jsmith[at]newcenturymedia.co.uk / alexnekrassov[at]newcenturymedia.co.uk

SOURCE City Index