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What Is Pairs Trading?
Pairs trading using spread bets is simply two transactions where one share is bought and another share, usually in the same sector, is sold short. An example of a spread bet pairs trade would be buying Vodafone and selling short MMO2, buying Ford and selling short General Motors, or buying Glaxo Welcome and selling short AstraZeneca.
The spread bet trader who utilises a pairs trading strategy is simply speculating that one share will out-perform the other, in both an up or down stockmarket. A Pairs trade is therefore not a bet on the overall stockmarket direction.
Balancing the Two Sides
- If Vodafone is trading at £1.20 and MMO2 is trading at £0.60 then buying £5 of Vodafone and selling short £5 of MMO2 would be an unbalanced trade
- The direction of the overall market would not be totally nullified
- If the overall market slumped and both stocks fell 15% the spread bet trader would lose money because he was in effect only half-short MMO2
So the ratio of each side is very important if you don't want to put an overall bullish/bearish trade on. To get the two sides balanced is very simple, just divide one into the other. So in the Vodafone case you should trade £1 for every £2 short in MMO2.
Some pairs traders like to get technical and perhaps work out the volatility or beta on each stock, and then marry up the two sides by this methodology. The beta of a stock is how much it should move for a given move in the FTSE 100. If the FTSE 100 moves up 1% then ABC stock with a beta of 2 is expected to move 2% higher, while XYZ stock with a beta of 0.5 would be expected to move only 0.5% higher.
An Example of a Pairs Trade - IBM v Microsoft
- The chart above shows IBM's price minus Microsoft's and also takes into account the ratio of the two stock prices as they are not the same
- Both stocks have risen since the October 2002 lows but the chart shows that IBM's stock price has been out-performing Microsoft's
- A spread better would therefore have made money buying IBM and selling short MSFT as a pairs trade
