What is pairs trading?
Imagine you wanted to bet on two runners in a race, but instead of picking who would win, you bet on the gap between them either shrinking or growing. This is similar to what happens in pairs trading, a strategy used in the stock market.
Pairs trading involves choosing two companies that usually move in sync with each other, like two tech companies or two banks. These companies are known to have a strong relationship, meaning their stock prices often go up and down together. In pairs trading, you would buy stock in one company you think is undervalued (going for a long position) and sell stock in the other company you think is overvalued (going for a short position) at the same time.
The goal isn’t to bet on which company will do better, but rather to bet on the relationship between their prices returning to normal if they start to drift apart. For example, if one stock drops in price while the other remains stable, you’d expect the lower-priced stock to eventually catch up, or the higher-priced one to fall. If this happens and you've set up your pairs trade correctly, you can make a profit from these adjustments. This strategy is designed to work even if the market is going up or down, aiming to be "market neutral."
Pairs trading example
Let's consider an example of pairs trading with two well-known publicly traded companies, McDonald's and Starbucks. These companies are both major players in the fast-food and coffee industry, making their stock prices somewhat correlated due to similar market factors like consumer spending habits and economic changes.
Imagine that typically, McDonald's and Starbucks stocks tend to move in sync because they are affected similarly by factors like changes in consumer confidence or commodity prices. However, due to a short-term issue, such as a supply chain problem, McDonald's stock price might temporarily fall more sharply than Starbucks'.
Here's how you would execute a pairs trade:
- Buy McDonald's stock (long position): Assuming McDonald's recent drop is an overreaction and will correct itself, you decide to buy shares of McDonald's, expecting the stock price to bounce back.
- Sell Starbucks stock (short position): Simultaneously, you sell shares of Starbucks short. This means you are betting that Starbucks’ stock will decrease in price, or at least not increase as much as McDonald's in the recovery phase.
- Wait for reversion to mean: The strategy here relies on the assumption that the prices of McDonald's and Starbucks will realign to their historical correlation. You expect McDonald's stock to recover or outperform Starbucks, closing the gap that was widened by the temporary drop.
- Close both positions for profit: If the stocks do realign according to your expectations, you would close both positions—selling the McDonald's shares at a higher price than you bought them and covering your Starbucks short at a lower price than when you sold it. The profit comes from the relative movement of the two stocks back towards their typical correlation.
This pairs trade allows you to potentially profit whether the market goes up or down, as it focuses on the relative performance of two correlated stocks rather than their absolute price movements.
Advantages and disadvantages of pairs trading
Capitalise on volatility in share markets
Take a position on moving share prices. Never miss an opportunity.
| Advantages | Disadvantages |
|---|---|
| Market neutral : Profits rely on the relative performance of the paired stocks, not the overall market direction. | Complex strategy : Requires a sophisticated understanding of market dynamics and correlations. |
| Reduced risk : By taking both long and short positions, the strategy aims to hedge against market volatility. | High management need : Involves constant monitoring and adjustments to maintain balance between pairs. |
| Exploits market Inefficiencies : Takes advantage of temporary mispricing between correlated stocks. | Dependence on correlation : Success heavily relies on the historical correlation holding, which could change unexpectedly. |
| Diversification : Trading in pairs can reduce risk by not relying on the performance of a single stock. | Costs : Transaction costs, especially from frequent trading and short-selling, could erode profits. |
Conclusion
In conclusion, pairs trading offers a strategic approach to the stock market that could potentially yield gains regardless of market conditions. By capitalizing on the correlation between two stocks, traders can mitigate risks and exploit pricing inefficiencies. However, the strategy demands a deep understanding of market dynamics, continuous monitoring, and efficient management to handle the complexities and risks involved, particularly in maintaining correlations and managing costs. Source: investopedia.com
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