Pairs trading is a trading strategy in which two securities that are very similar in most aspects, but differ in one key aspect, are traded against each other in a long-short fashion. By going long one security and shorting the other, you eliminate most risks save for the one you wish to exploit. This article discusses the strategy and how it might be made easier by employing exchange-traded products (ETPs).
In the stock market there is no sure thing. Even if you are very confident about an investment idea, some unforeseen event could turn the tables on you. Pairs trading attempts to control outside risks--chiefly market risk--allowing you to focus on just one at a time. For example, let's say that you are a fan of Apple (AAPL) products and when the iPad was released you anticipated that it would steal e-book reader market share from Amazon.com's (AMZN) Kindle. Using a pairs trade you could have bought shares in Apple and sold short shares of Amazon. Two months after the release of the iPad, shares in Apple were up about 7% while shares in Amazon were down 5%.
Pairs trading can reduce market risk, but it can increase single-security risk. For example, let's say that you witnessed the success of the iPod and how it changed the way people listen to music. Perhaps back in the summer of 2008 you thought that the new version of the iPhone would be a similar success and continue to steal market share from other smartphones such as Research in Motion's (RIMM) BlackBerry. If you bought shares of Apple in June 2008 you would have lost money for at least a year despite the fact that your investment thesis was correct. Apple shares decreased about 20% from June 2008 to June 2009, as the broader market--represented by the S&P 500--decreased about 30%. However, if you had used a simple 1-for-1 pairs trade, simultaneously buying Apple and shorting Research in Motion, you would have netted a positive 20% because Research in Motion decreased 40%, twice Apple's 20% loss.
Pairs trades have been used for a long time, but how can ETPs make them easier? It is difficult enough to come up with one investment idea, but in pairs trading you need to have two ideas. Buying shares in Apple was not enough--you also had to know whom Apple was going to beat and what companies face risk profiles similar to Apple's. On top of this, you had to be able to locate shares of Research in Motion to short.
ETPs can solve at least one of these problems. The variety of ETPs available means that you can use a security providing broad exposure to the same asset class, index, or industry to pair with your stock trade instead of deciphering which company's shares would be a good match with your initial idea. Unfortunately, within Europe, shares of many ETPs are difficult to locate to borrow for shorting, and even if they can be found can be prohibitively expensive to borrow.
Here is an example of a pairs trade using ETPs. Let's say that you fear that last year's Gulf of Mexico oil-spill crisis will cause much greater long-term liability and reputational risks to BP (BP.) than the market currently perceives. However, if energy prices increase, so could shares in BP--but perhaps less than those of other energy majors. Here, a potential pairs trade would involve shorting BP shares and going long an energy industry ETF such as the Source STOXX Europe 600 Optimised Oil & Gas ETF (SC0V).
Once you've identified the securities you wish to employ to execute your pairs trade, the next step is to calculate the appropriate size of your bets. Correlation is a commonly used statistic to measure the strength of the relationship between the returns on two securities. A more useful metric is a security’s beta, which can tell you how much you need to short one side of the trade to balance out the long side of the trade. For example, let's say you like Deutsche Bank AG (DBK) and you want to do a pair trade, going long shares in Deutsche Bank and shorting a EURO STOXX 50 ETF. How much would you need to short the EURO STOXX 50 to balance out a EUR 5,000 position in Deutsche Bank? Using the beta, we can calculate how much we need to short using simple multiplication. Deutsche Bank's beta to the market (as represented by the EURO STOXX 50) was 1.5. Take the initial position size (EUR 5,000) and multiply it by the beta (1.5), and you get EUR 7,500 worth of shares in a EURO STOXX 50 ETF to short. Of course, using historical estimates for correlation and beta is risky, as these variables can be unstable.
In summary, pairs trading can be a great way to act upon an investment thesis while simultaneously minimising market risk. Assuming an appropriate product is available for borrowing at a reasonable cost, ETPs can be good partners in a pairs trade.
Michael Rawson, CFA also contributed to this article.
