Financial Spread Betting - Trading Pairs

So you've done your research, and found a company that you want to place a financial spread bet on. But one of the problems with any form of equity investment, be it through share ownership or via financial spread betting FTSE stocks, is the risk that the market as a whole, or the sector in which your chosen company operates in, goes down. Is there any way around this, and can we look at a 'market neutral strategy' for trading?

Happily, the answer is yes, if you use spread betting. There is a way to remove or at least minimise that kind of risk, and it's called 'Pairs Trading'. This takes advantage of one spread betting's general advantages, being that you can bet on things going down as easily as you can bet on things going up. This luxury isn't available to most traders of equities. Of course, there is a bit more work than simply picking a winner here because - as the name implies - you pick a pair of trades to construct your position. Here's how it works.

The theory is blindingly simple. If you believe that 'similar' financial instruments are impacted the same way by general market movements, two banks in the financial sector for example, then you might 'buy' one and 'sell' the other. If the financial sector in general goes up, you will gain on the stock you 'buy', but lose an equal amount on the stock you 'sell'. What you have just done, in a rough and ready way, is give yourself some insulation from general movements in that sector. Big deal, you might say, but how do we use this to actually make money? So far all we have proved is that each time we bet, we can lose the same amount we make?

The answer lies in your choice of pair. What you are looking to do is take the company you originally identified as your chosen investment - we will call this your 'A choice' - and find another company in the same sector that you think has the least underlying chance of it's share price going up. Let's call this your 'B choice'. The trick now is to 'buy' your A choice and sell your B choice. Make sure the underlying value of each bet is the same size. What you are effectively doing now is mitigating the impact of market movements (on the assumption that general market/sector movements will affect both equally) and set the two stocks in a fair race against each other. You are no longer betting on one stock against the price you purchased at, you are now effectively betting that the underlying performance of your A choice share will beat the underlying performance of your B choice share.

Of course the key to executing this strategy successfully is to find highly correlated stocks and then to pick the better performer as your 'A choice'. Good luck!

Stuart Smith writes extensively on Financial Spread Betting subjects and is the owner of leading website www.spreadbettingftse.co.uk