Can you explain pairs trading
If I find two highly correlated stocks and short one while going long to the same dollar value on the other is this a dollar neutral transaction? If I go short $100 on one CFD and long $100 on another shouldn’t my account be the same (less fees, of course)? Also I'm expecting the shares to move in a "wave form", and some things I'm reading indicate that they should be moving in sync, but at different values. This doesn't make sense.
Firstly, yes this is a dollar neutral transaction.
Secondly, see the table below to explain why your account will not necessarily be the same.
Day Long Short Profit/loss per share 1 $100 $100 0 2 $102 $101 +1 3 $105 $102 +3 4 $98 $92 +6
Profit/loss per share
So as you can see on Day 1 the CFD account is the same, but as the shares move on day 2-4 the trader will make a profit(loss) because the correlated shares usually do not move in the same ratio.
In response to the third part of your question, there are five different scenarios with a pairs trade.
(1) Both shares could go up
(2) Both shares go down
(3) Long share goes up, short share goes down
(4) Long share goes down, short shares goes up
(5) Both shares stay the same
The scenarios you want are (1), (2) and (3). You do not want scenario (4) or (5).
Disclaimers: The views expressed in this article are those of Richard Avery-Wright and is not intended as general advice. This does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.
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