Pairs trading is a strategy that involves buying one stock and simultaneously selling another stock. Pairs trading aims to profit from the spread between the two stocks (i.e., their price differential) and not the broader market moves. Therefore, it is a market-neutral trading strategy.
While a key benefit of pairs trading is that it is market-neutral, managing these trades is much more complex and challenging than regular long-only trades.
So, is it a winning strategy?
Let’s break down pairs trading for beginners.
Pairs Trading Strategies
Pairs trading strategies fall broadly into two primary categories: mean reversion trades and divergence trades.
A mean reversion trade involves performing a statistical regression to determine the average price spread and the typical reversion pattern between stock pairs. The trader is looking to find highly correlated stocks (usually a historical stock regression with at least an R-squared of 0.6) at historically high spreads and with a typical reversion pattern showing both stocks converging within a reasonable trading timeframe (usually under three months).
A mean reversion strategy is usually applied to stocks with similar unlying fundamentals, such as nearly identical business models. For example, Snap (SNAP) and Meta Labs (META) run social networks monetized primarily through online advertising. As such, they are exposed to very similar economic forces, and the trader may reasonably speculate that both stocks should trend together, and a divergence is a trading opportunity.
Divergence trades, conversely, are bets that two stocks will diverge in price and not mean-revert. Divergence trades can be made on stock in similar industries if the trader believes that one company will have a significant advantage in the future (such as a new product launch). However, divergence trades are often used to express an opinion on broader industry or economic issues.
For example, below, a trader believing Wells Fargo and Bank of America will eventually return to their natural correlation may open up a spread trade with the long leg on Bank of America (BAC) and the short leg on Wells Fargo & CO (WFC).
One key benefit of pairs trading is that it is a market-neutral strategy. This means the trader’s profits are not dependent on the overall market’s direction. This can be a valuable advantage in volatile markets.
As the returns from a market-neutral strategy are independent of those of the broader market, the strategy is often combined with a regular market long/short strategy to enhance returns without increasing the portfolio risk.
Pairs trading can be much more complex to implement than a long-only strategy. The long part of the trade is relatively straightforward, as the trader can simply purchase the stock.
However, for a beginning investor, the short leg of the trade can be much more difficult as many brokerages will not make their stock bowering and margining facilities available for individual investors.
There are two alternatives to shorting the actual stock. First, multiple short-ETF products now encapsulate a short position in an ETF that can be purchased and traded similarly to any stock. Short-ETFs are mainly for sector exposure, so the trader may consider opening a pairs trade on one stock versus a sector.
For example, a trader believing Goldman Sachs will outperform its peers could purchase Goldman Sachs (GS) stock and buy the ProShares Short Financials (SEF) ETF, which gives inverse exposure to the broad financials sector.
Second, the trader could create the short position by purchasing a long-dated, “in the money” put option on the stock to be shorted. This type of option gives a similar return profile to a short position.
Although pairs trading can be a powerful tool for expressing complex views on markets, managing these trades is much more complex and challenging than regular long-only trades.
The first issue to note is that there is always a cost to maintaining a short position that is not always obvious when calculating return forecasts. If the trader can access their brokerage’s stock borrowing facilities, there will be a quoted cost to borrow the stock, which can vary enormously between stocks. Although not immediately apparent, short ETFs also charge a stock borrowing fee.
If the trader uses a put option, the value of this option will ‘decay’ over time, and hence, a loss will gradually accrue on the trade.
Managing the risk on a pairs trade can also be much more complex as the correlations of the stocks can change over time, which will invalidate the trade. Therefore, one must repeat the statistical analysis of the trade regularly to ensure the original trading thesis is still valid.
Pairs Trading Conclusion
Pairs trading is a market-neutral strategy, which can be a valuable advantage for unpredictable markets. However, managing these trades is much more involved than regular long-only trade, making it difficult for newbies.
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