Also note that the whole of the Foreign exchange business is one giant pairs trade because if you buy £/$ you are in effect doing 2 trades - buying Sterling and selling short the US Dollar.

Suppose the UK supermarket sector is of interest and you prefer Tesco's prospects to Sainsbury's. Buying Tesco and selling short Sainsbury's would be an example of a pairs trade -

• Buy Tesco shares, and
• Simultaneously sell short Sainsbury's

It is important to note that this is not a bullish trade or investment in Tesco or indeed a bearish trade on Sainsbury's.

With a pairs trade you are focussing on the direction and price relationship between the two stocks. If you were to just buy Tesco stock without shorting Sainsbury's then you could only make money if Tesco's share price rose. But with the pairs trade it's possible to make money even if both stock prices fall. See the following table.

Note: Assume that for this example both Tesco and Sainsbury's stock prices were at 100p when the trades were initiated and an equal number of Tesco's shares were bought and Sainsbury's shares sold short.

1. The first rule of pairs trading is there has to be some correlation. For example, Tesco and a Gold Mining firm have little in common, but Tesco and Sainsbury's are obviously a perfect match
   
   
2. Make sure both sides of the trade are worth roughly the same in monetary terms. For example go long £3,000 of Tesco and short £3,000 of Sainsbury's. If you buy £3k of Tesco and short only £1k of Sainsbury's then all you've done is reduce the risk on a predominately long Tesco trade
   
   
3. A good way to chart the price differential between 2 stocks is to enter the daily price information into Excel. This way the weightings of the 2 stocks can be considered

You cannot short stocks through a traditional stockbroker. So for Pairs trading, either CFDs or spread bets must be used.

• LearnMoney.co.uk CFD section
• Spread Betting section

The advantage of both of these financial products is that you can use leverage, but remember leverage is a double-edged sword in that it is your best friend in positive trades but your worse enemy if you use too much and the trade goes wrong.

So whenever you're given the opportunity of using leverage it's always a good plan to use less rather than more.

CFDs for example will offer between 10:1 and 20:1 leverage meaning a cash sum of £1,000 can control stock worth £10,000. But you don't have to use all the leverage on offer - try to think of it like a tap that can be turned fully on, half on, quarter on etc.

Perhaps you might be bullish on the overall market direction so go long on a ratio of 2:1, or buy £2,000 worth of stock for every £1,000 that's shorted.

Once you understand how pairs trading works then it opens a whole new world of trading opportunities. Here are some trading ideas;

The Achilles heel of pairs trading is costs are doubled, and remember costs are not just commissions they include the cost of buying/selling on the bid/offer as well.

This is why unless you have great market access alongside ultra cheap commission it's most probably a better idea to use pairs trading for medium to longer term trading.