Pairs Trading

Have you ever wanted to short a stock, but were anxious that the markets could take off and you’d end up losing your shirt? Pairs trading is a trading strategy that empowers you to hedge against this risk.

Holding single shares can be a tricky business. Even if you’re right about a share being undervalued, if the wider market falls while you’re holding it, odds are that it will fall too. This is where pairs trading can come useful. Pairs trading is a market neutral strategy, i.e. a trading strategy that is not dependent on the overall direction of the market, and one that involves exploiting the difference in value between two historically related shares in the same sector. Thus, a pairs trade (sometimes referred to as a hedge trade) is one in which you go long on one share and short on another in the same sector. And pairs trading is not limited to just shares – you can take a view whether a stock, a sector or even an entire index is over or underpriced in comparison to another asset. For instance, you could go short on the S&P 500 while shorting the Nikkei 225 – a trade on the relative strength of a Japanese recovery versus that of the USA.

Here it doesn’t matter how the wider market performs – both assets could rise or both could fall. What’s important is the way the shares trade relative to one another i.e. the pricing correlation between the two markets. By placing a long bet on one share while taking an equal and opposite short bet on a related share, you are simply betting on the differential between those two securities, rather than the direction of the overall market so in such cases it doesn’t matter if both the share and the wider market fall. You will still gain as long as your chosen share falls by less than its counterpart. The theory here is that since both shares are in the same sector, they will be behave in a similar way and will thus be influenced over a long period of time by the same factors in the market. Which means that in the long term they will both move in the same direction – up or down. However, if one company is perceived as stronger than another, then the stronger company enjoys a higher price rise than the weaker company in the shorter term. The challenge is to find two stocks whose relative value will have sufficiently diverged enough to enable you to make a worthwhile profit.

You should only trade one thing against another if you think that the relationship between the two things is wrong. Pairs trading requires you to place two spread bets simultaneously; an up bet on the market you regard as stronger and a down bet on the weaker one.

And thus when the value of the company shares eventually return to normal you will have potentially benefited from holding two positions instead of one. In this way you avoid exposing yourself to the ups and downs of the global market as you are simply speculating on the the difference between two related company share prices. For example, let’s take the telecommunications sector and assume that the market is bullish about its prospects. Suppose we pick two companies in the sector, Cable ABC Plc and Cable XYZ Plc. If Cable ABC Plc has posted rising profits over the last three years while Cable XYZ Plc posted a profit warning only two months ago, then we can safely say that Cable ABC Plc is the stronger company.

How does Pairs Trading Works?

In some cases, traders have stronger views on how two companies will perform in relation to each other than they do about the general market direction.

This trading strategy involves studying how the historic price of one market performs in relation to another, and using this as a cue to identify whether the price of a market will go up or down from its present position, and potentially when.

Pairs trading commonly involves taking two stocks from the same industry, like BP and Shell for example. These stocks tend to follow each other, as they’re affected by the same types of economic factors. If you notice that BP is trading at a discount to Shell (relatively speaking), then this provides you with a trading opportunity. If you buy BP stock and sell an equal value of Shell shares you can profit as the shares move back to their historic ‘equilibrium’. Your goal here is to profit from the fact that one stock has become too expensive relative to the other.

How do you do a Pairs Trade?

Definition: Selling securities you do not own in the hope of buying them back at a lower price in the future and pocketing the difference.

This trading strategy can be utilised in situations where you have a clear perspective of the relative performance of two similar assets or companies in the same industry. You can also use it to take advantage of short-term trading opportunities. For instance, you might be of the opinion that the market has overreacted on a piece of news, such as a poor trading statement, that pulls the price of the company’s shares down sharply compared to those of a competitor operating in similar circumstances.

Example:

Action:  You place an up bet on Cable ABC Plc and a down bet on Cable XYZ Plc.

Scenario 1:  The telecommunications sector enjoys a re-rating. Shares in both Cable ABC Plc and XYZ Plc go up. More specifically, share in Cable Plc rise by 10% while shares in Cable XYZ Plc rise by 3%.

Result:  Profit gain from Cable ABC Plc compensate for losses in the down bet for Cable XYZ Plc.

Scenario 2:  The telecommunications sector enjoys a re-rating. Share in both Cable ABC Plc and Cable XYZ Plc go up. More specifically, share in Cable ABC Plc rise by 10% while share in Cable XYZ Plc rise by 10%

Result:  Break even

Scenario 3:  The telecommunications sector does not enjoy a re-rating but contrary to expectations suffers a de-rating. Shares in both Cable ABC Plc and Cable XYZ Plc go down. More specifically, share in Cable ABC Plc fall by 10% while shares in Cable XYZ Plc fall by 15%.

Result:  Profit gain from the down bet on Cable XYZ Plc compensate for losses in the up bet for Cable ABC Plc.

 

Example:

Opinion:  David decides in November 2009 that Nokia was overpriced in its sector.

Action:  He placed a sell bet in Nokia and a buy in Ericsson, hoping that Nokia would fall and Ericsson would rise. By placing a pairs trade, he was not directly exposed to overall market risk because he was effectively hedged. If the sector fell, he would make profits on Nokia and lose on Ericsson.

Result:  The pairs trade was a success. Nokia fell from 1700 to 1420 and Ericsson rose from 1300 to 1730 over the year.

 

Example:
Instead of betting on two companies in the same sector a pairs trader can also be done on two companies from different sectors. For example, one from a cyclical sector and another from an anti-cyclical sector. In particular, one stock is in retailing and the other is a utility.

 

How do identify suitable Pairing Opportunities

In pairs trading, the aim is to profit from one share outperforming the other. So suppose you’ve checked a chart and noted that one share usually trades at twice the price of another. However, in the last couple of weeks the pricier share is trading at almost the same level as its peer. Why? Maybe the market is worried about the upcoming departure of its CEO. But whatever the reason for the drop in the company’s share price, you believe the market has overreacted. In this instance you could go long on the first company using a spreadbet while shorting the second. Here you are basically betting that the normal pricing relationship between the two shares will be restored at which point you will close both trades and make a profit in the process. Some well-known examples of stocks that are historically similar are Coca-Cola and Pepsi, Shell and BP and BHP Billiton and Rio Tinto.

A good way to spot these opportunities is to use a charting software package to display the relationship between two assets. By dividing one price by the other, we get a line showing the price ratio over time, leading up to today’s level.

Pairs Trading

The chart above displays Glaxo’s stock price in relation to Astra’s, compared to the recent average of this relationship. One possible trading strategy would have been to sell Glaxo and buy Astra whenever this relationship gets significantly above 1 and rolls over negatively. Similarly, one could buy Glaxo and sell Astra when the ratio dips some way below 1 and then turns upwards.

So the next time you want to go long on a particular share, at least do consider taking a short position on one of its competitors from the same sector too.

Trading Risks

One problem with this strategy is that the time period of mean reversion might turn out to be much longer than you initially anticipated. Also, as the ratio between the two assets widens, more traders will take your same position; where all the traders happen to be on the same side of the trade and are all underwater and getting increasingly impatient. In such circumstances, if traders start closing positions, this might push the spread out even further.

Another major caveat with this trading strategy is that its dependent on a pricing relationship between two shares that has held in the past but which you cannot assume that it will continue indefinitely. This is where research is important since if a development has materialised to either company which has broadly changed the relationship between the two shares (say, the company had to recall one of its key products from the market due to it being a health hazard), then relationship between the two companies’ share prices may not hold anymore. Additionally since you enter two trades, you have to pay two sets of spreads which makes pairs trading more expensive than a conventional directional bet.

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