Trading Pairs - Term Of Trade Featured In The Herald Sun

As with anything we try to do in trading, we attempt to buy the strongest looking prospect and sell the weakest looking prospect. In pairs trading however, we do the above on two highly correlated securities.

The idea is to look within sectors, correlated currency crosses, even correlated commodities, and identify the best looking prospect for a long and the best looking prospect for a short. Then we will look to execute a long and short trade respectively at the same time.

The idea is that each trade will provide a natural hedge against the other. We are not so much interested in the performance of each position in isolation, but rather the performance of each position as part of a single, combined trade. Let’s look at an example.

One of the best ways to do a pairs trade is to look at a specific sector in the market, let’s say the Healthcare Sector (XHJ). We note two stocks in the XHJ that are experiencing very different fortunes in the market. CSL Ltd (CSL) is in a nice uptrend, whilst Cochlear (COH has endured a rough time over the past five months.

This would be an option for a “pairs trade”. We would look to go long the stronger stock (CSL) and simultaneously go short the weaker stock (COH).

To read more visit Carl at the Australian Stock Report How To Buy Shares blog