I’ve heard I can still make money on a stock if I tak a long and short position simultaneously in two related shares?

Yes, that’s a valid trading strategy that is commonly referred to as pairs trading. Pairs trading involves taking a long and short position simultaneously in two related stocks in the same sector. The expectation in this trading strategy is that the long share will outperform the short one.

Note that to make a profit you will have to reverse both trades later. Let me introduce you to the pairs trading strategy…

This trading strategy consists in taking two shares from the same sector, like Tesco and Sainsbury for example. These two shares tend to move in the same direction, as they’re impacted by the same sorts of economic fundamdentals and news.

Should we notice that Sainsbury’s stock has started to look cheaper than Tesco’s, then that opens for us a trading opportunity. If we buy the Sainsbury’s shares and short an equal value of Tesco’s shares, we stand to gain as the shares move back to their historic price levels..

The nice thing of this trading strategy is that it is ‘market neutral’. All other things being equal, if there is a Dairy scandal say, then both shares are likely to head down, but the profit on the Tesco short should offset the loss on the Sainsbury’s long. Of course, should the market go up, the oppositie happens, and we don’t benefit directly from a market rise.

What you are trying to do here is to profit from the simple fact that one share is too expensive relative to the other. By buying a spreadbet on one stock and simultaneously selling a spreadbet on another, both of which are in the same sector, a pairs trader aims to profit from the different fortunes of two competitors while also stripping out sector risk.

We can take this ‘pairs’ strategy and apply it to index markets too. For instance, say the FTSE 100 has underperformed the FTSE 250, so a trader might go long of the 100 and short of the 250. The market then crashes. Both indices plummet, but the trader gains on the short FTSE 250 position and loses on the long FTSE 100 bet. But if, as predicted, the FTSE 100 held up better than the FTSE 250, the spreadbet has still been profitable despite the sizable swing. This is because pairs trading is about making bets on stocks and indices relative to each other, as opposed to absolute terms.

Pairs trading is not risk-free though. Get both of them wrong, however, and you’ll be on the hook for some serious losses. Pairs trading can be a popular trading strategy, particularly in volatile times, because you can see where sentiment outweighs fundamental analysis, as sentiment is what drives a stock to be oversold or overbought.

“A pairs trader will look for two shares with a high positive correlation; wait for a divergence in the share prices and then trade on the expectation that the stocks will revert to their historic correlation.”