Pairs Trading: A Market Neutral Strategy

Pairs trading is a market-neutral trading strategy that has not been widely publicised, yet many institutional money managers and hedge funds use it successfully.

In this discussion, we will look at its application to the derivatives markets.

What is it?

In technical speak; it is a 'non-directional, relative-value investment strategy' that identifies two similar companies whose stock prices are out of their historical trading range.

The pairs trading strategy is essentially an arbitrage system whereby the trader is able to make profit from the divergence of these two stocks. In other words, the two individual shares normally move together in unison, however one is now either falling behind or leading, and thereby changing the underlying ratio. In Theory, pairs trading is a fairly low-risk, market-neutral strategy, and the direction of the overall market does not affect its gains or losses.

How it Works

By being long (or bullish) one Stock and short (or bearish) another the effect of larger market trends is minimised and the performance of one stock relative to another is emphasised.

Options Market

Exchange Traded Options (ETO's) traders will use calls and puts to hedge risks and exploit volatility. A pairs trade in the options market might involve writing a call for a security that is outperforming its 'twin', and matching the position by writing a put for the 'twin' (the underperforming stock). As the two underlying stocks come back to equilibrium, the options become worthless, thereby allowing the trader to profit from one or both of the positions.

Contracts For Difference (CFDs)

Following the same methodology, if the CFD trader finds a convergence or divergence between two similar stocks, they would simultaneously buy and sell CFDs of the two stocks.

Example

Hypothetically, the analysis found that the underlying ratio between Woodside Petroleum (WPL) and Oil Search (OSH) had changed well outside its normal range, suggesting that Woodside Petroleum (WPL) is over priced and that Oil Search (OSH) is under priced relative to each other.

A CFD trader would sell WPL CFD and buy OSH CFD. Once the share prices have levelled out in respect of each other, you would unwind the position by buying WPL CFD and selling OSH CFD. Irrespective of market conditions, you have made money.

Hence being described as risk free.