Day Trading Stocks
The recent volatility in global markets has made day trading extremely difficult.
The US market can close up 600 points, but the Australian market can actually close down the following day.
How does this make any sense and more importantly, how can day traders make money trading these markets?
Over the past six months, we have seen the VIX, surge by over 100.0% on the back of Sovereign debt issues in Europe and uncertainty over a “double dip” recession in the US – this has made trading very difficult.
Volatility Index - VIX
How you can make money trading these markets?
The strategy known as pair trading has the potential to increase returns without being dependent on the direction of the market.
Pair traders don’t mind what the market does - simply seeking to profit from the relative performance of two related stocks. Used by institutions, hedge funds and investment banks for over three decades, it remains surprisingly under-utilized by the average investor.
When the correlation between the two stocks temporarily weaken (i.e. one stock moves up while the other moves down), the pair trade would be to short the outperforming stock and to take a long position on the underperforming stock, betting that the "spread" between the two would eventually converge (or come together).
The main advantages of pair trading are as follows:
(i) The Pair Trade helps to reduce sector- and market-risk. For example, if the whole market crashes, and the two securities fall along with it, the trade should result in a gain on the short position and a negating loss on the long position, leaving the profit close to zero in spite of the large move.
(ii) Pair Trading is a mean-reverting, non-directional strategy, betting that the prices will eventually revert to their historical trends. Back test results show that this is the case among specified sectors.
(iii) Pair Trading is a substantially self-funding strategy, since the short sale proceeds may be used to offset the long position.
(iv) Pair Trading provides investors the ability to trade across various asset classes and global markets (not only restricted to stocks). The ability to go long and short in different securities reduces cross country risk and enhances the diversification of a portfolio.