Adopting a pairs trading strategy for overall risk reduction [2]



Pairs trading scenario 2 — the stockmarket falls:


Continued from Part 1:Introduction to pairs trading

Similarly, for the same spread bet trader with a ‘Buy Barclays + Sell Abbey Plc’, in the event that the overall stockmarket falls , the combined position would see a gain on the Abbey Plc short sell but a loss on the Barclays buy trade. Once again, provided that Barclays out-perform Abbey Plc, the overall portfolio shows a net profit. In this case, out-performance would mean that as the overall market falls, Barclays declines by a smaller percentage than Abbey Plc does.

The combined spread betting position would look like this:

—fall in the price of Barclays results in a loss
—fall in the price of Abbey plc results in a profit
—Overall pairs trading portfolio profit = gain from Abbey minus loss from Barclays

Determining market-direction-neutral value of shares

There are a number of approaches to this. Hedge funds that use pairs strategies would typically adopt more statistically-derived methods such as assessing the relationships between the historical volatilities of the two securities in question.

For practical spread betting purposes, a more basic approach can be utilised to good effect. Essentially, you have to ensure that you have similar net exposure such that a 1% move in one share has an equal cash effect on your spread betting account as a 1%. Using the example above, if both Barclays and Abbey were trading at £1 a share, then you would bet exactly the same number of pounds per point on each of them (in opposite directions). On the other hand, if Barclays was trading at £5 per share and Abbey at £10 per share for instance, then to get equivalent exposure you would need to bet twice as many pounds per point on Barclays as you would on Abbey. This 2:1 bet ratio is derived by simply dividing the two share prices.

Summary

The crucial elements in using the strategy outlined here are choosing the right candidates to pair and determining the appropriate equivalent amount of shares to trade in the respective companies where the strategy is applied to stocks. Furthermore, while a relationship may well be identified between two securities that make them good candidates for a pairs trading strategy, such relationships may not persist hence traders need to be on the look out for signs of a breakdown that may affect expectations about relative performance.

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