CFD Pair Trading Strategy
What is Pair Trading?
Back in the 1980’s quantitative equity traders realized that stocks within the same sector would move more or less in step with each other. That would mean for example when Citibank shares rose, the stocks of other major financial institutions would usually increase in value as well. This observation had very real fundamental foundations in finance theory and crowd behavior. Should one firm in a certain sector report strong earnings, there is a strong probability that the other members of the industry group would experience similar results in their own accounting. What’s more, when one stock is being run up or sold off at a momentous pace, the market participants who felt they missed the majority of the advance or decline in the target stock will look to jump into a trade in related shares.
From these humble beginnings, the spread (or pair) trading strategy has quickly reached into the retail speculative community and – as those individual traders have been granted access to different products – into different asset classes. However, while spread trading has only recently grown in popularity in the equities market and among individual investors, macro economic traders have been using this strategy in many markets for years. Relative growth and interest rate forecasts have been the basis for spread trading on government debt and equity indexes. Commodities have allowed speculators to exploit the disparity in global demand and supplier/producer price lags. Uncertainty the direction of risk appetite and the stability of financial markets have even encouraged cross market pair trading. There are many other applications of this basic trading concept; and in this article we will cover a few possibilities for three of the major security types.
Pair Trading Equities Indexes
Spread trading in individual shares initially allowed investors to pursue a profit while limiting overall risk; but picking good candidates for this strategy in real time was certainly difficult and time consuming. There is a near endless supply of stocks that can be scanned for long-term correlations that have recently broken down. What’s more, liquidity is always a factor and a stock can fight the trend for some time thanks to very different underlying fundamentals. To counter these problems, macro traders have turned to the deep liquidity and diversification of broad equity indexes.
Economic Releases
One of the most common ways to pair trade major equities indexes is to look for a short-term divergence between the stock markets of two major economies. Since globalization has spread throughout the world’s economies, industrialized markets have seen their equity benchmarks more or less move in the same direction over time. This is clearly evident in the chart of the United States’ Dow Jones Industrial Average and Japan’s Nikkei 225 Index over the past five years. Over the long-term, the day to day and week to week changes between the two have been relatively consistent. However, there are clearly periods when the correlation breaks down; yet the two almost invariably will find their way back into lockstep. Usually, these major departures are driven by the release of a major piece of economic data (like a central bank announcement, a GDP report, inflation numbers, etc.); but their impact is ultimately limited. As such, trading opportunities are generated when the divergence is judged to be too large of held for too long. When this extreme has been met, a long position is taken on the undervalued index and a short position in the dear index.
Session Follow Through
Another exploitable strategy that takes advantage of multiple equity indexes is the natural follow through from one session to the next. With banks and fund managers around the world seeking more complete diversification and precise hedges when exchanges are closed, daily fluctuations in equity markets from one time zone will naturally find follow through when the next major session opens. And, while near 24-hour futures markets allow traders to hedge the overnight adjustments, there are still significant gaps and follow through moves at the session turnovers. Taking advantage of this, a macro trader could sell or buy an index after a major move just before the close and take the opposing position in the soon to be active index from a different time zone to look for the reaction. As an example, if the Dow Jones Industrial Average experienced an unusually strong rally through its active session, a trader could take a long position in the Nikkei 225 for potential follow through and take a partial hedge by shorting the Dow.
Pair Trading Commodities
Spread trading has been a common strategy in the commodities and futures market for some time. Investors and hedgers have sought to isolate costs in the production chain (like crack spreads between crude oil and gasoline or heating oil) or forecasting demand or supply shifts by trading different expiration dates. However, besides these traditional opportunities, more macro commodity strategies have begun to surface.
A Hedged Commodities Basket
Since the turn of the century, few investment vehicles have grown in popularity as quickly as commodity baskets. A number of funds have different components and variable weightings for a bevy of trading strategies. Some indexes look to take advantage of ever present carry costs while others collect the value in the inflation and speculative-based premium from commodities. With a spread trading mentality, this basket can be mimicked, but in such a way that major losses can be partially hedged. In most commodity baskets, the exposure is primarily to the long side – leaving an investor open to considerable volatility and drawdowns. To counter this drawback, a trader can setup their own basket with various longs and shorts (i.e. long energy and short metals or short crude and long heating oil) for access to the commodity arena without involving the buy-and-hold dynamic.
Trading Economic Trends With Commodities
Another popular strategy for pair trading commodities is to use different goods to express a view on regional or global economic trends. For years, gold has been considered an inflation hedge; and traders have bought the precious metal in times when fiat money loses its value to physical goods and services. However, once again, a long gold trade brings with it considerable systemic risk and opens the door to the potential for significant capital losses. To hedge some of the risk in a pure gold exposure position away while still taking advantage of the commodity’s inflation correlation, a spread trade could be made by buying gold and selling crude oil. This will help to diversify away supply pressures and other unwanted facets of the group while still allowing access to an inflation trade.
Pair Trading Fixed Income
Government debt (US Treasuries, UK Gilts, Japanese Government Bonds, etc.) are some of the most actively traded and deeply liquid instruments in the global market. Major banks and investors buy and sell the so-called ‘risk-free’ instruments for steady returns or when other markets are deemed too dangerous to trade in. However, this asset class too has pair trading possibilities for the savvy macro trader. Whether taking advantage of diverging growth and interest rate potential or looking for a hedge to further reduce risk, spread trading government bonds offers a host of options.
Using Debt To Play Interest Rate Differentials
In a global market place, just like in local arenas, capital chases the highest return with the lowest level of risk. In fact, this happens to be the foundation underlying most strategies including the popular Forex carry trade. For carry traders looking to collect the most appealing yield differential, they need to borrow in one country and invest in another country. Since they are looking to capture the yield spread without incurring additional risk, they usually do so in government debt and other low risk instruments. As more and more traders follow the same path to higher rates, differentials between the debt instruments grow. Pair trading can replicate this most basic of strategies while eliminating some of the additional risks seen in similar investment vehicles. For example, buying the Australian 10-year bond and selling the US 10-year Treasury bond produces a rather steady equity curve (the blue line below represents the interest rate spread between the two bonds) while avoiding exposure to the exchange rate (indicated by the orange line). As interest rate expectations lean in favor of the higher yielding instrument, the spread position will produce a positive return while simultaneously hedging most other factors driving the broader debt market.
Unlimited Possibilities
All of the previous pair trading examples involved two of the same instrument; however, there are infinite possibilities for cross market spreads. For example, during a period of uncertainty and risk aversion throughout the world’s financial markets, a strategy that looks for rising interest rates yet hedges the influence of risk trends would be a long 10-Year Treasury Bond CFD and long a gold CFD. With interest rates on the rise, both gold and the debt instrument will produce positive returns. On the other hand, when a swell in risk aversion should rise, the drop in yield will be partially offset by a rising in gold (as gold is often considered a safe haven investment). Ultimately, the possibilities are limited only to one’s imagination.
