Four ways to profit from pairs

Which is easier to predict: how far the share price of Morrisons will rise over the next few days, or whether you think Marks & Spencer will do better than the northern grocer? Both may sound like tough questions. But what if you find out a key executive is defecting from Morrisons to M&S?

Suddenly you have a clear trading opportunity. Odds are that the M&S share price will surge while Morrisons' will slump. You could respond by just buying M&S shares or shorting Morrisons. But that leaves you open to swings in the broader market. What if, having bought M&S, all retailers suffer a bad few days? Or having shorted Morrisons, the wider market rises unexpectedly? This is where you need a pairs trade, which is designed to profit whichever way the broader market turns.

How to do it

A pairs trade involves simultaneously placing an up bet on one asset (this could be a share, currency, commodity indeed, almost anything these days) and a down bet on another. The easiest and quickest way to do this for a private investor is by using spread bets. Added benefits are that gains are not taxed and you will suffer no stamp duty when you buy.

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The strategy actually involves four trades. In the example above you would initially place an up bet on M&S (you 'buy the spread') at, say, £3.80, and a down bet on Morrisons ('sell the spread') at, say, £2.90. Let's say the M&S share price then jumps 20p to £4, while Morrisons sags to £2.60. You now close out both trades.

At first glance the overall profit looks pretty meagre 20p on the M&S leg and 30p on Morrisons. However, the beauty of spread betting is that you can gear up. The amount you choose to risk on each bet is negotiable. But let's say your original bets were at £10 a point (one point being a 1p movement in the share price). Now our profit on the M&S up bet is £200 (20 point x £10) and the profit on the Morrisons bet is £300. That's £500 in total minus perhaps £40 to reflect the fact that the opening prices above didn't reflect the typical bid-to-offer spread (say 2 points, or £20 on each stock). This spread is how your broker makes its money. In practice you may also want to weight your bets so you're equally financially exposed to each share. That would mean betting nearer £13 a point on Morrisons (since £3.80/2.90 = 1.3 times).

What can go wrong?

There's one big flaw with a pairs trade. Had M&S fallen and Morrisons risen the opposite of what you expected you could have lost pretty fast too (around £400 in the above example). However, as with all spread bets, there's a solution. It's called a guaranteed-stop. The idea is that you specify a price at which you want each leg of the pairs trade closed. So on your M&S up bet it might be set a few pence below your opening price of £3.80. That way should M&S subsequently dive you won't get wiped out. Some brokers charge for guaranteed stops typically the spread on your chosen share is slightly wider. However, at Spreadex.com you can place guaranteed stops for free. So, where should budding pairs traders be looking to make money?

Single stocks

The trick is to find pairs of share prices that have diverged. Charts are one way to spot this happening (see graph above). Or you can track the relationship using a simple multiple. For example, say two firms, A and B, have share prices of £10 and £5, so the relationship is two (£10/£5). What's more, that ratio has held more or less constant over the past two years. If it suddenly moves to three, you know that either company A has shot up or company B has dropped. A good trade would be to short A and buy B, assuming the relationship will re-establish itself. Failing that you need a good reason why it has suddenly changed permanently.

Right now, for example, says Ian O'Sullivan of Spreadex, the Lloyds and RBS share prices have diverged. Usually the two track each other closely but the gap, or 'spread', is currently wide. There are no guarantees it will close soon, of course. But a trade that shorts Lloyds and buys RBS could pay out.

Sectors

Another option is to trade whole sectors against each other. At IGindex, for example, you can buy or sell UK and US sectors using spreadbets. Given how far cyclical stocks have surged this year, and how far defensive shares have lagged, one good bet looks to be to sell a cyclical sector, such as miners (which depend on economic growth for their profits), and buy a defensive one, such as utilities (which are less sensitive to tough economic conditions).

Currencies

All currencies automatically trade in pairs if you are betting that sterling will rise, it must be against another currency that is set to fall. So, for example, you could buy the GBP/USD pair as a sterling bull or sell it as a sterling bear. At the moment, notes Jim Mellon, the battered dollar looks set to stage a recovery while the euro is now facing headwinds as more trouble wafts out of eurozone members such as Greece and Spain. So you could try a short EUR/USD trade via your broker.

Politics

The beauty of spread bets is the sheer range of things you can bet on. How about the predicted number of seats that Labour and the Tories will win at the next election? Enthusiasts can track news, such as the results of each UK opinion poll as it is released at sites such as Politicalbetting.com or Bettingpro.com. If you think Gordon Brown's recent polls bounce has been overdone then you could buy Tory seats and sell Labour seats at a site such as Sportingindex.com.