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Five ways to put pairs trading to work

by , 10 September 2015

Pairs trading involves putting on a long trade and a short trade simultaneously.

The idea behind this strategy is that you're in a better position to profit by taking a market neutral position.

As long as the asset you buy does better than the asset you short, you're going to be in a money making position.

So how can you use pairs trading?

Let's take a closer look at five different ways to put pairs trading to work…

Pairs trading scenario #1: Market sector versus market sector

You can use pairs trading to play one market sector off against another one, Brian Hunt and Ben Morris in The Crux explain.

For example, you think the property sector is going to do well, but the resources sector is going to come under pressure. You could buy the property sector and sell the resources sector.

As long as property does better than resources for the length of your trade, you’ll be in the money.

Pairs trading scenario #2: Stock versus stock in the same sector or industry

You could decide to play one stock off against another stock in the same sector or industry.

For instance, you may think Vodacom’s prospects are much better than MTN’s. If this was the case, you could long Vodacom and short MTN.

Pairs trading scenario #3: Stocks versus the market

Another way to use pairs trading is to buy one specific stock and short a stock market index.

For example, you think that Standard Bank is a better company than most in the JSE’s Top 40 Index. If Standard Bank was also trading at a cheaper price than the overall index, you could buy Standard Bank and short the Top 40 Index.

Whether you’re successful or not comes down to you being right about Standard Bank against the Top 40, not the performance of the index itself.

Pairs trading scenario #4: Commodity versus commodity

Pairs trading also works in the commodities market.

For example, if you think gold is cheap compared to oil, you could buy gold and short oil.

The success of this trade comes down to your analysis.

Pairs trading scenario #5: Country versus country

You can also use pairs trading to trade one country off against another.

For example, you think US stocks are going to do better than UK stocks, so you could buy an ETF tracking the US market and sell an ETF tracking the UK market.

The outcome of your trade comes down to whether you’re right about the US market performing better than the UK market. It doesn’t depend on what the global markets are doing.

So there you have it. Five ways to put pairs trading to work.

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Five ways to put pairs trading to work
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