Special Feature
The beauty of a pairs trade (essentially a long position v a short position) is that it essentially provides you with a natural hedge in the event of a shakedown in the market (like what we are currently experiencing at time of writing!). The short position would be expected to mute any losses on the long side and of course, if you have chosen the ‘pairs’ correctly, then you would expect the short trade to fall farther than the long trade. Readers will recall our piece about pairs trading in the Feb/March edition of the magazine (page 70). The key with the pairs trade, aside from actually choosing the right trade ideas, is to get your respective long and short wagers correct. I suggest that new readers take a look at this article to gain a thorough understanding but put simply, what you need to remember is that your wagers on both sides should equal the same percentage move, i.e. for a 1% move in both trades you make and lose the same amount. This is very important. Many a novice pairs trader has come unstuck through getting the long and short monetary base wrong! To quickly refresh readers as to how you calculate the respective wager let’s take the FTSE v the Dow Jones potential pair. At time of writing, the FTSE is trading at 5600 and the Dow at 12000. If you wanted to enter a long FTSE v short Dow trade in the equivalent of £10 per point, then you would divide the long side, the FTSE (5600), by the short side (12000) = 0.467. What this means is that for every £10 of the FTSE you wager on the long side, you need to wager £4.67 on the Dow on the short side. Let’s check this. Say that both the FTSE and the Dow move 5% we can check we have our calculations correct. The FTSE would have moved from 5600 to 5880 and the Dow would have moved from 12000 to 12600.
38 | www.financial-spread-betting.com | June 2012
On the long FTSE trade we would have made £2800 (280pts x £10) and on the short Dow we would have lost £2800 (600pts x £4.67) - exactly matching each other. Always perform a test calculation using a predetermined percentage move (5% is easy) to verify you have your stakes correct. Now let’s look at Spreadbet Magazine’s 5 potential pairs ideas with a brief overview as to their respective reasonings: