The Fundamentals of Pair Trading

One of the hardest things to do when trading is managing risk. Often, there are so many risk factors at play in a given asset, it can be hard to protect yourself and still profit.

For example, the S&P 500 (and most of its components) trades up and down every day based on countless global developments, such as changes in commodity prices, political headlines, economic data or even merger and acquisition news.

Obviously, no asset on Wall Street is entirely risk-free (or everyone on the planet would own it), but that doesn’t mean there aren’t ways to minimize risk.

To help mitigate the risk of an unforeseen market- or sector-wide event, traders often use a type of trade called a pair trade to insulate a particular trading idea.

WHAT IS A PAIR TRADE?

When making a pair trade, a trader takes a long position in one stock and an equal-sized short position in another. Overall, the pair trade results in a net neutral position, but it allows the trader to isolate whatever it is he or she likes about one stock and/or dislikes about the other.

If both stocks go up, the pair trader pockets the difference between the gain in the long position and the loss in the short position. The inverse is true if both stocks go down. Assuming the relative performance of the short position is better than the relative performance of the long position, the trader is profitable on one of the trades no matter what the overall market does thus mitigating risk.

WHY PAIR TRADES ARE USEFUL

A trader that has identified a bullish trend or pattern in a retail stock could go long the stock, only to discover that plunging oil prices sent the entire market (along with the stock) down sharply the next day. Oil prices have little, if anything, to do with the fundamentals of most retail companies, but this type of event is common.

If this trader simply took a long position in the retail stock, the position would have lost money. However, if the trader had paired the long position with a short position in a rival retail stock or index ETF, such as the SPDR S&P 500 ETF Trust (NYSE: SPY), the pair trade may still have turned a profit depending on the difference between the gain and loss of each trade.

IT’S ALL RELATIVE

The key to a successful pair trade is relative performance. Pair traders are sacrificing the full gains or losses of their primary position in the name of safety. Instead, they are targeting only the relative performance of their primary position compared to the performance of its pair trade.

The beauty of pair trades is that they can work in almost any market conditions. For example, imagine a trader wanted to go long JPMorgan Chase & Co (NYSE: JPM) at the beginning of 2009 during the heart of the financial crisis. Traders that remember 2009 know that the market didn’t bottom until March of that year, and JPMorgan stock declined 27.1 percent in the first two months.

However, if that trader had paired a long JPMorgan position with a short position in Citigroup Inc (NYSE: C), he or she would have turned a huge profit on the trade at one of the worst times for bank stocks in history.

The long JPMorgan trade would have produced a 27.1 percent loss, while the short Citigroup trade would have produced a 79.0 percent gain. Overall, the pair trade would have resulted in a 51.9 percent net gain.

TAKEAWAY

The most important part of any pair trade is identifying the appropriate pairs. Once a trader chooses a primary long or short position, he or she needs…

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