Pairs trade your way to profits

Once you get the hang of single spread bets, there's a way to combine two trades together to make money. It's called a 'pairs trade'. Here's how it works.

The idea is that, rather than placing a straight bet on the direction of, say, a single share, sector or index, you bet on one over- or under-performing against another.

So, for example, you might watch two share prices over time in the same sector say Tesco and Morrisons, or BP and Shell, or Barclays and HSBC.

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Let's say you notice that the share price of one of the stocks firm A is usually three times the other firm B. But today it seems the relationship is only two to one. If you are confident that this is down to short-term factors and the normal gap will soon be restored, you can profit by placing an up bet on firm A and a down bet on firm B.

As the gap between the two prices widens you'll make money.

However, note that to do so you'll need to close out both trades, meaning that in total you will have suffered four bid-to-offer spreads (two on each leg of the combined pairs trade).

Another way to use pairs trades is to place a downbet on, say, the retail sector (as my colleague Bengt Saelensminde recently suggested) if you believe it will face a tough ride in 2011, and an upbet on either another, more secure, sector or perhaps the wider market as represented by the FTSE 100 index.

Or, you could go global and place an upbet on the US economy via the S&P 500 and a downbet on the embattled eurozone via the Dow Jones Stoxx index. The possibilities, once you look at global stock market indices, are almost endless.

One word of caution all pairs trades involve two trades being placed simultaneously. Not only does this mean you'll incur two spreads, but you also double the risk of a trade misfiring if you get both bets wrong. So keep bet sizes small - especially early on - and ask your broker about guaranteed stops to cap losses.