Pairs Trading

This pairs trading strategy has been used by professional investors for some 60 years now and it is sometimes referred to as statistical arbitrage, relative value arbitrage, and long and short equity. Pairs trading; i.e. buying one asset and simultaneously selling another, is in fact a lower-risk strategy of speculating on the relationship between two prices.

Hedging is a way to protect yourself if the commodity or stock you are trading should take an unexpected dive, if you’ve gone LONG, or spikes up, if you’ve gone SHORT. You can also use spread trades to hedge your regular, traditional, non-spread trade positions in shares or commodities.

Pairs trading is a trading strategy that relies on combining two stocks into a pairs trade; like BP and Shell for instance. The idea behind the trading strategy being to spot two highly correlated shares in the same sector where the performance has diverged. For instance, the stock price of two companies in the same industry sector might normally behave similarly over time. However, let’s assume that one stock has lately risen a lot more strongly than the other. If the price-ratio between two related companies reaches extreme levels then it might be potentially be worth selling one stock and buying the other in expectation of a reversion to the mean. You could then look into opening a short position on the overbought share and go long in the oversold one in anticipation of a return to the longer-term equilibrium.

Shorting is significantly more about relative performance than “longing”. You’ll always make the easy money shorting those that are going to do badly against their peer group, not those that are the gold medal winners of their peer group!

“With a pairs trade, you are hoping that the profit on one bet will outweigh any loss on the other, so the direction of the market doesn’t matter. A hedging strategy involves betting against an existing shareholding or liability.”

Going back to our BP and Shell examples, if we note that BP has started to get cheaper than Shell, then that gives us an opportunity. If we buy the BP shares and short an equal value of Shell shares, we can profit as the shares move back to their historic relationship. What’s nice about this trading strategy is that it is market neutral. Should oil stocks crash, then both shares should go down, but the profit on the Shell short, should compensate for the loss on the BP long.

Other common pair examples would include GlaxoSmithKline (LSE:GSK) and AstraZeneca (LSE: AZN), Sainsbury and Tesco or Barclays and LLoyds. Taking the case of Sainsbury and Tesco for instance, both happen to be large supermarket chains that compete in the same market with largely similar exposures and operating strategies (and both are trying to kill each other to get people into their stores!) which makes them ideal for a pairs trader to compare.

Likewise we can consider Sainsbury and Morrisons. If you believe that for instance Sainsbury’s shoppers will abandon the store for cheaper substitutes, but Morrisons is likely to have a good year, you could sell Sainsbury’s shares while buying the equivalent in Morrisons. The position as a whole will be market neutral as the profit is dependent on the relative performance of the two shares rather than the direction of the market (handy if you believe that a Greek default could push stocks off a cliff!). This strategy is not limited to corporate shares either; you could for instance identify a link between the price of gold and oil or gold and the USA Dollar or UK crude oil (Brent) against USA crude (West Texas Intermediate).

“Pairs trading is when spread traders spot any significant deviation in the price movements of similar stocks within the same industry sector. The spread trader would then attempt to sell the outperforming stock and buy the underperforming rival, on the hope that both stocks would eventually converge.”

Pairs Trading Spread Betting Strategy

Researching out individual shares from a sector can prove tricky. Even if you believe that a stock represents long term good value, it could still be dragged down by a fall in the industry sector in which it operates. Pairs trading can be useful here since as opposed to taking a one-way directional punt you take a hedge reduce risk by going long and short positions in two related stocks simultaneously.

Through pairs trading, a spread trader aims to make a net profit by taking two opposite spread betting trades on a pair of related shares. Combining long and short positions – with ‘buy’ and ‘sell’ bets – can reduce the risk of getting the direction of the market wrong. The pairs trading spread betting strategy would involve short selling the higher-priced stock and buying the lower priced one in the belief that they will move back together. If they do, the trader stands to make a profit.

Step 1: Selection

To create a pairs trade, a spread trader first needs to seek two shares that are closely correlated; i.e. whose share price tends to move in line with each other on a day-to-day basis. This is because the strategy revolves around identifying two instruments that tend to move together, but which have got out of line recently.

For the sake of simplicity, let us assume that these two related stocks are Bank A and Bank B.

Step 2: Value:

Subsequently, the spread trader needs to evaluate whether one of the stocks is underperforming or whether it is overvalued compared to the other. If the spread bettor believes that Bank A is undervalued in relation to Bank B, he will open a long position on Bank A whilst simultaneously opening a short position on Bank B.

Step 3: Trade

These two opposite financial trades need to be worth about the same amount. For instance, if your position on Bank A is worth £2400 (300 price x £8 stake), your spreadbet on Bank B should also be worth £2400 (1200 price x £2 stake). If the trades are not of an equivalent market size, the spread trader is left with a net directional speculative position and is simply reducing the risk of the larger trade as opposed to creating a scenario in which he can profit from the pair irrespective of whether the wider markets move higher or lower.

The Result:

If the wider market was to rise, the trade from trade Bank A – the undervalued share – would, at least theoretically close the gap and return a profit greater than the loss incurred by the ‘short’ Bank B trade. Likewise, if the market was to fall, Bank A’s share is likely not to fall as much as Bank B’s share, thereby putting the Bank B trade into a profit that outweighs the Bank A loss.

Pairs Trading: Practical Example

Let’s say at the beginning of 2008 you think the market is going to be in for a really hard time because of the emerging financial crisis. You already own stocks like IBM, Barclays, Google, and Citibank among others. You could simply sell all your shares at the beginning, and then buy them back at the lower prices months into the crisis. But if you did this, you’d have to pay capital gains taxes on each stock when you sell it. And then you’ll have to pay them again when you eventually sell what you bought at lower prices.

But as there are no capital gains involved with spread trading, you can make a spread trade to go SHORT (sell) the FTSE100, NYSE, or NASDAQ (all three for example, or just one, or specific shares within them). Let’s say the FTSE100 dropped 20%, and your specific shares fell by a similar rate. But because you hedged your trade by doing a spread trade to sell, you’ll have made 20% on that trade, which will offset the 20% you lost on your existing shares in your account.

Share vs Sector Trades

Pairs trades can also be utilised to profit from individual stock that fare better than their overall sectors. For example, if you believe that the banks sector looks weak and has further to fall but you believe that HSBC will hold up better than its rivals, you can place a buy bet on HSBC and a sell bet on the bank sector. As long as HSBC falls less, or rises more, than the wider sector, your spread bets will make you money.

Another way to take advantage of this type of relative analysis is to check performance in relation to the sector. The basis here being that if you are looking for value shares within on sector, the companies that are faring best in relation to a sector over, say, the last 3 months may be the ones that start moving first if the sector sentiment improves, whereas the stock that are likely to fare worst (in relation to the sector) may in reality be basket cases that one wouldn’t want to touch.

The downside of pairs trading is that of course in some situations you might have to hold positions for weeks, if not months, for the shares correlation ratio to come back in line and allow you to exit the trade for a profit which can lead to considerable financing costs to keep the position open. This means it is important to check how much your spread betting provider charges you in finances cost particularly if your provider charges you financing on both long and short positions. Other sudden events like a takeover announcement or shock profits warning could also blow your positions out. However, as a whole pairs trading is considered a safer trading strategy than taking an outright long or short position on one security.

Index Trading

Pairs trading can also be used to trade the correlation between two index markets. This involves looking back at the performance of an index in relation to another and then using this information to figure out whether each of these indices will go up or down from its present trading level. For instance you could take a spreadbet trade of £5 per point that the FTSE 100 will rise over a set period of time, while the DAX will fall. If the FTSE 100 index were to rise 100 points over this time, while the DAX were to fall by 40, you would be in profit net of £700. Of course if both indices were to move in opposite direction to both your trades, you would be standing at a loss so such trades have to be made with care.