A pairs trade is simply buying a stock that you feel may perform well, while shorting another you think may underperform against it, and netting the difference.
Think of it like forex trading where, if you buy EUR/USD, you’re simply expecting the euro to appreciate against the USD. The key is to make sure your total equity (number of shares x market price) matches off, so you don’t have a directional bias.
Even if both stocks go down in price, you’re simply hoping that the one you have bought will go down less as a percentage over the course of your trade than the one you have shorted. The major advantage here is that you are effectively removing much of the ‘market risk’ from your trade, so even if the ASX 200 is down 3%, it should have limited impact on your strategy.
The strategy is defined as trading two stocks in the same sector and with similar thematics, with the idea to take advantage of news flow, valuation discrepancy and subsequent price action (e.g. buying Wesfarmers and selling Woolworths).
What is a long/short strategy?
This is a similar strategy, however choosing what you buy and sell is not confined to two closely tied companies. Here, traders can really branch out and look at stocks in different sectors, including commodities, indices or even fixed income products.
Bear in mind that if you put a stop loss on both legs, only one may get triggered, providing you with a directional bias. So this strategy, while in theory may carry less risk, is for those who can closely monitor their positions.
Who would look to deploy this strategy?
The ability to take advantage of any market condition is one of the benefits of a CFD, whether it’s going short into a down-trending market, or range trading in a sideways moving market. Pairs trading is used by both retail and sophisticated traders alike, and can be an effective weapon to have in one’s trading arsenal.
Investment banks and hedge funds generally all run long/short portfolios, and depending on an individual’s experience, it can determine how advanced your strategy becomes.
Things to consider when selecting pairs or other asset classes
Other variables can come into play when pairs trading as no two companies are 100% correlated.
- The ASX 200 may be up 3%, while Lynas is up 5% and Arafura Resources is higher by 9%. While both stocks are leveraged to rare earths, one is about to produce and the other is still in exploration; variables such as liquidity and market cap will determine potential volatility.
- Look at recent price action to see if there’s been a strong move in the anticipation of an event, as the market could be one step ahead of you.
- The actual catalyst behind your trade is also important in determining how long you hold your position. For example, if you are buying for an event-driven outcome, there’s a good chance you’ll hold the position for a shorter time frame than perhaps a valuation discrepancy, where NAB may be trading on a 12% discount to CBA.
Key trading example
Interest rates have recently been cut, and the credit markets are pricing in another rate cut in December. The fact that the money markets are also now pricing in a rate cut in New Zealand is interesting, and lends weight to our call that Kathmandu (KMD) may continue to outperform Harvey Norman (HVN).
KMD has been outperforming since late September 2010, and if you chart this, it is in a strong uptrend versus HVN. There appears to be no reason to believe that this will change, given the growth profiles of both companies:
You decide to use $1000 ($500 on each leg) as margin with KMD, trading at $1.94 and HVN at $2.12. You buy 257 shares in KMD ($500/$1.94), while shorting 235 shares in HVN ($500/2.12)
In two weeks time, KMD trades to $2.50 and HVN trades to $2.20.
KMD – 257*$2.50 = $642 (a gain of $142)
HVN – 235* $2.2 = $517 (a loss of $17)
Your profit would be $125, minus commissions and interest.
Looking to try pairs trading? Take a CFD position
We offer a wide range of markets, at highly competitive rates.
If you are not already an IG Markets client, apply online in minutes, and begin trading CFDs today.
Disclaimer: IG Markets provides an execution-only service. The material above does not contain (and should not be construed as containing) personal financial or investment advice or other recommendations, or an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of the above information. Consequently any person acting on it does so entirely at his or her own risk. The research does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.
SHARE: