Pairs Trading - What's It All About?
Pairs trading is a form of spread trading where one stock is bought and another sold short (click here for an introduction to short selling) on the assumption that one is going to outperform the other, regardless of the overall stockmarket direction. It is therefore possible with pairs trading to make money in all sorts of market environments which contrasts to plain vanilla investing where money can only be made in a rising market.
This article follows on from last month's newsletter where we introduced the important yet simple concept of using charts to determine relative strength and hence which stocks should be bought or sold within a sector.
For example, if you wanted to buy into the banking sector which stocks should you buy, RBS, HBOS, HSBC etc because although the stocks within that sector will generally move up or down together the amplitude will be different, and this is what the concept of relative strength tries to exploit.
Pairs trading is not just restricted to the stockmarket, it is very heavily practised in all types of markets especially the bond and interest rate complex. In these markets it is generally referred to as spread trading. Also note that the whole of the Foreign exchange business is really one giant pairs trade, after all if you buy £/$ you are in effect buying Sterling and selling short the US Dollar.
A Simple Pairs Trade
The UK supermarket sector is of interest to you and for example Tesco just keeps getting it right whereas Sainsbury's shows continued lacklustre results with still no light at the end of the tunnel. Buying Tesco and selling short would be an example of a pairs trade.
It is important to note that this is not a bullish trade or investment on Tesco or indeed a bearish trade on Sainsburys. With a pairs trade you are just focussing on the direction and price relationship between the two stocks. If you were to just buy Tesco stock without shorting Sainsburys then you could only make money if Tesco's share price rises, but with the pairs trade it's very possible to make money even if both stock prices fall. See the following table.
(Note: Assume that for this example both Tesco and Sainsburys stock prices were at 100p when the trades were initiated)
Of course it's also possible to lose with pairs trading as well but losses occur not because of the overall market direction, rather the price relationship that you predicted was incorrect. So with the case of Tesco/Sainsbury s perhaps Tesco made some disastrous acquisitions alongside Sainsburys finally getting their business in order with this being reflected in a higher share price.
Some Pairs Trading Rules
- The first rule of pairs trading is that there has to be some correlation. For example, Tesco and a Gold Mining company have very little in common, but Tesco and Sainsbury's have everything in common
- Make sure both sides of the trade are roughly the same in monetary terms, for example go long £3,000 of Tesco and short £3,000 of Sainsburys. If you buy £3k of Tesco and short only £1k of Sainsburys then all you've done is reduce the risk on a predominately long Tesco trade, and while this is fine if the sector goes higher you most probably won't be able to make any money with lower prices
- For most people it's not a good idea to leg into trades. By this we mean buying stock A today and 'hoping' that stock B (which you want to short) will rally in order to sell at a better price. In a situation like this what normally happens is that stock B's shareprice never rallies and in fact moves lower leaving your trade in tatters
- Charting the relationships between two stocks is often hard without the right software because it's no good just subtracting stock A's shareprice from stock B's because the price weightings have to be taken into account. Therefore look to get hold of historical stock prices from say Yahoo Finance, input them into a spread sheet and manipulate the data to chart it using the spreadsheets inbuilt charting facilities
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