Treat Companies as Couples: Pairs Trading - dummies

By David Stevenson

In pairs trading (in the UK and around the world) you find a pair of historically correlated stocks and, when the correlation weakens (when one stock goes up while the other stays the same or goes down), you go long on the stock that’s fallen and go short on the stock that’s risen on the assumption that the correlation will return.

Your aim with this strategy is to make a profit regardless of the direction of the market: in simple terms you’re hedging your market exposure (aiming to make money in all markets). Or you can look at the process as being that you’re now suddenly market neutral: in other words, you make money regardless of the direction of the overall market.

The easiest way to explain pairs trading is to use the example of two of the world’s most famous businesses.

Coca-Cola’s great rival is Pepsi Cola and vice versa. In theory these companies are very similar: they operate in the same market, sell similar things and (most of the time) boast fairly similar operating margins. Yet their shares almost certainly don’t behave in the same way.

This difference in behaviour is partly down to the fact that many different investors hold a big chunk of shares in these corporate giants, but also because many of those investors are nervous that those shares may be hit by company specifics.

Equally, investors also have a relative view of the attractiveness of shares in each company; that is, one company’s shares may be more attractive than those of the other.

For hedge funds the obvious way to proceed with these potential discrepancies is to treat the companies as a pair and go long (buy) one and short (sell) the other.

As a pairs hedge-fund trader, you monitor two similar stocks and aim to buy the oversold issue and simultaneously sell the overbought issue, exiting — that is selling both stocks — when the relationship returns to its norm.

By using this long/short pair, if the market generally goes up both your Coca-Cola and Pepsi Cola positions rise in price, though the stronger share should rise more provided that your analysis is correct and is ultimately recognised by other investors.

Thus, the profit from your successful position more than offsets the loss from your short position in the weaker stock. As a bonus, you receive a rebate from your stockbroker on your short position (typically the risk-free rate of interest).

If you think that pairs trading is for you, do what many practitioners of market-neutral long/short share trading do and balance your longs and shorts in the same sector or industry. By being sector neutral, you avoid the risk of market swings heavily impacting a specific industry or sector.

In addition, choose pairs that are in deep sectors: that is, with a large amount of liquidity (lots of shares on offer).

Here are two unique, important characteristics of pairs trading:

  • You’re not trading the individual stocks based on their direction, but trading the difference between the two stock prices. This approach is called trading the differential and makes this type of strategy very different from other trading methodologies.

  • You’re moving away from a strategy that involves following the market’s direction. Instead you’re focusing on trading the chart of the difference of the two correlated stocks.

Successful pairs-based hedge-fund managers are the ones with the greatest ability to select a basket of long stocks that perform better than the basket of shorts. If the longs don’t outperform the shorts, then no matter how market-neutral your portfolio, it isn’t going to generate meaningful returns.

Pairs trading seeks to achieve a consistent return by earning small, steady profits on lots and lots of positions, instead of trying for large gains that may end up becoming big losses. This tendency to earn small, steady gains characterises market-neutral long/short share funds in general, resulting in annual returns of about 10‒12 per cent, without leverage in good years. To enhance returns, some funds do resort to leverage.