Adopting a pairs trading strategy for overall risk reduction

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What is pairs trading?

In its basic form, this strategy consists of two transactions in which a security (such as a share, or an equity index) is sold while an equivalent amount of another, similar or related security is bought, leaving the overall spread betting position neutral.

The crucial element in implementing this sort of spread betting strategy is ensuring that the two securities are similar and ought to be affected by similar fundamental factors. So for example, they could be two stocks within the same sector such as Barclays and Abbey Plc in the financial sector or Ford and General Motors in the auto sector for example. Also, the trader needs to ensure that an equivalent amount of shares is bought and sold in the respective companies so that the position is actually neutral to overall market direction.

As mentioned above, in its purest form, trading pairs is a non-directional strategy, the idea being that the trader is able to derive profits from the differences in performance between the two shares without having any net directional exposure to the wider market.

Of course, the trade can also be structured to give the bet a directional bias. If you instance, you felt that Barclays would outperform Abbey irrespective of the market direction, then rather than buy Barclays shares and sell an equivalent amount of Abbey shares, you could skew the transaction by buying more Barclay shares than is required given the short in Abbey. This way, you have a net long position such that if the market rises and Barclays does outperform Abbey, then you would make a lot more than if you had a market-direction-neutral amount of shares.

So what is the point of pairs trading?

Essentially, a spread bet position based on this strategy seeks to take advantage of expected relative performance between two similar stocks. Taking the financial sector example, a ‘Buy Barclays + Sell Abbey Plc’ pairs trade would be based on the expectation that Barclays would outperform Abbey in any market condition. Since the trade is non-directional, this means that the spread bet trader is speculating that Barclays would out-perform Abbey Plc whether the overall stockmarket goes up or down.

Scenario 1—the stockmarket rises:

For a trader with a ‘Buy Barclays + Sell Abbey Plc’ pair trade, in the event that the overall stockmarket rises over the period of the trade, the combined position would see a loss on the Abbey Plc short sell but a gain on the Barclays buy trade. So long as the Barclays move exceeds the Abbey Plc move, the paired trading portfolio shows a net profit.

In this scenario, the overall account position would look like this:

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

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