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Pairs trading: A trading strategy that works whichever way stocks go

by , 09 September 2015

If you're looking for a trading strategy that can make you money whether the stock market rises or falls, pairs trading could be the answer.

Pairs trading isn't a strategy many retail investors use, but it's one professional investors have used for years to their profit.

So what exactly is pairs trading? And how does it work?

Let's take a look…


What is pairs trading?


Pairs trading involves combining two trades together. You take a position in two different assets, but you treat these trades as one.

When you put your pairs trade on:

  • You short one asset (you sell); and
  • You long the other asset (you buy).

What this does is give you a market neutral pair of trades, Brian Hunt and Ben Morris in The Crux explain.

This is the most important aspect of pair trading. If you have a market neutral trade, there’s no bias towards up or down movement in prices. For example, you put R10,000 into a trade that gains when prices rise and R10,000 into a trade that gains when prices fall.

What this means is you’re not reliant on the market to rise to make a profit. You just need the asset you buy to do better than the one you short.


An example of pairs trading in action


You buy R10,000 worth of Company ABC and short R10,000 worth of Company XYZ.

If Company ABC rises 10% and Company XYZ falls 10%, you make R2,000. This comes from the R1,000 profit from each of the two trades in the pair.

If Company ABC rises 10% and Company XYZ climbs 5%, you make R500. This is a R1,000 gain from Company ABC and a R500 loss on Company XYZ.

Or it Company ABC falls 10% and Company XYZ drops 15%, you make R500. You lose R1,000 on the Company ABC side, but gain R1,500 on Company XYZ.

The only way you can lose money on this trade is if Company XYZ does better than Company ABC.

So there you have it. A trading strategy that works whichever way stocks go.

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Pairs trading: A trading strategy that works whichever way stocks go
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