How to trade pairs
Back in the mists of time, Alfred Winslow Jones, an investor in hedge funds, had a simple idea. Buy shares that are likely to go up and offset them with short positions in shares that look overvalued. That way you should get superior returns and can be indifferent to whether or not the market moves up or down.
It is a short step from that to the idea of pairs trading. It is essentially the same idea, but using two stocks that are fundamentally similar, for example from the same industry. This could be, for example, two banks, two drug companies, two water companies or two mobile phone networks. Often there is logic to doing this, say when such essentially similar companies have markedly different market ratings or significantly different yields.
The trade is essentially arbitrage. It is a bet that ultimately the market will act so that the rating of one stock converges with that of the other. The idea is to profit from the narrowing of a disparity in the stockmarket rating of two similar companies.
Since UK stock futures are now no longer accessible by ordinary private investors, the best way to place a trade like this is probably via CFDs or spread bets, shorting the stock you feel is the more expensive of the two, and 'buying' an equal money amount of the one you feel is the cheaper.
The argument against this type of trading boils down to two things.
One is that dealing costs will be higher, since there will be two lots of commission in CFDs, or two bid-offer spreads to surmount in a spread bet. In either case, these costs need to be overcome before you reach profit. In the case of a CFD, the position is mitigated slightly because the financing credit on the short position will partly offset the financing cost of the long position.
The big plus point, however, is that this strategy ought to mean that you are insulated from the ups and downs in the market. If the market as a whole rises, or falls, the effect on your exposure will be neutral. In that event, both stocks should rise or fall in tandem.
What you are interested in here is a change in the relative valuations of the stocks, not their absolute levels. That is how you make money from pairs trading.
Pairs trading isn't without risk. The stock you have bought could bid for the stock you have shorted. That's about the worst possible combination of events since the ratings will diverge rather than converge if this happens. But generally risk is minimised.
We should also remember that CFDs and spread bets are both trades that operate on the basis of borrowed money, in the shape of margin. So, if you are confident that your case is a strong one - that one of the pair is significantly overvalued and one undervalued - then the margin element allows you to profit from quite small changes in the relative value of the two stocks.
You need to keep an eagle eye on dealing costs to make sure you can profit from the trade. It is, for example, perfectly possible that the impact of the bid-offer spread or commission could substantially cut the theoretical return from the trade.
I have to confess that in 20 years of investing I have never tried a strategy like this.
While it sounds a logical way to make money, there is one basic flaw. You have to be certain that the two companies in question, however seemingly similar they seem, are actually alike.
Where market ratings differ, this is often for a reason - typically the quality of the underlying business or the company's management. If that's the case, the differences can persist for a long time, certainly long enough for even the most persistent pairs trader to lose patience and cut and run.
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