Pairs Trade: Real Examples and Profit Potential

by Darwin on April 3, 2012

Pairs trades can be a great supplement to your investment portfolio if you’re just a passive investor or an active trader.  I’ve personally done several different types of pairs trades over the years and have had varying degrees of success.  Below, I’ll lay out some real-life examples and some recent trades in the news that will jump out at you as something we all should have thought of!

How Does a Pairs Trade Work?

The premise of a pairs trade is that you want to profit from a “comparative” or “directional” benefit of one outcome over another similar option.  For instance, if you are worried about overall market risk, but are relatively confident that one stock is going to outperform another stock in the same industry, you could buy an equivalent amount of shares of your preferred stock and sell shares short on the opposing stock.  The beauty is that you can make money in either an up or down market, as long as you chose the right side of the pairs trade.  Here’s a real-life example that will probably make you kick yourself for not doing it yourself (I am, because I saw this happening in slow motion and never acted on it!):

 

Pairs Trade Examples

Over the past few years, we’ve all seen the Blackberry versus Apple saga unfolding.  However, when it became evident that the iPhone was to become the dominant brand amongst consumers (and with the iPad supplementing the brand even in the corporate segment, it became apparent the Blackberry couldn’t compete), a really good pairs trade would have been to go long Apple (AAPL) and short Research in Motion (RIMM).  Here’s a 1 year chart of the two:

Pairs Trade

  • AAPL vs RIMM – So, for the example above, you could have basically taken out the market risk (if either both dropped or both ran up quickly) and made 82% on your long Apple shares and made 76% on your short RIMM shares for a grand total return of 158%.  But your “real ROI” would be much higher since you had a net zero dollars out of pocket.  How is that?  Well, the presumption is you went long the same amount you went short, so you bought $10,000 in Apple shares and sold short $10,000 in RIMM, so it’s a net zero dollars out of pocket.  Now, of course there are margin requirements and you will have needed some capital in your trading account to act as collateral, but that could have been invested in something else, even a low-risk investment to bring in some income while serving as margin collateral.
  •  Market Inefficiencies – People like to think the market is efficient (which it often is), but inefficiencies do occur, as I pointed out recently in my article on arbitrage investments.  For a real trading example I exploited, there have been a few cases where closed-end funds went WAY above or beyond the net asset value (NAV) and a reversion to the mean was imminent.  The problem was, as many investors learned the hard way, sometimes, a premium or discount situation can grow even more extreme and it may take a very long time (or never) for the trend to reverse.  However, when a reversal is imminent in your estimation, as it was mine, you can make easy money like I did with this gold pairs trade.
  • Other Pairs Trade Examples – The same strategy can be employed on any number of investment classes ranging from bonds (pairing up long vs short duration Treasuries), country ETFs (say, assuming the US will outperform Europe), commodities (the age-old gold/oil ratio or gold/silver ratio), currencies and more.

 

How to Do a Pairs Trade

All traditional online trading brokerages that I’m aware of allow this sort of trading as long as you sign up for the margin account and understand the risks (more on that below).  If you don’t have an online account now and are interested in the various deals out there, here are some top-rated trading outfits with going deals:

 

Zecco has trades for $4.95


Zecco – Trade Up. Pay Less.

ETRADE has a deal where you can trade for FREE for 2 months! Pretty cool way to try out some new strategies

Options House has $3.95 Stock Trades

 

Get $100 When Opening an Account with OptionsExpress


 

Pairs Trade Risks

The key thing to be mindful of with pairs trades is that like any investment with a decent profit potential, there is commensurate risk that you’re assuming (otherwise, free markets being what they are, investors would flock to risk-free investments with high returns).  Since you’re betting on a particular “directional” outcome, if the trade moves in the wrong direction, you are subject to the losses on the other side of the trade.  Before entering into a pairs trade, you have to do a realistic assessment of what can go wrong, how large your loss may be and whether you can withstand such a loss given your capital position, time horizon and personal risk tolerance.

 

Have You Ever Done a Pairs Trade?

Would You?

{ 7 comments… read them below or add one }

JT April 4, 2012 at 9:11 am

Pairs trades are awesome, especially since you can use the short trade to fund the long. Unlike those goofy 120/20 funds, you actually get some serious leverage at 2:1.

It’s interesting how AAPL has become a virtual pure-play on mobile technology. High margins on the physical products plus the app store cash cow make AAPL THE phone company. That’s something I would have never, ever predicted five years ago. RIMM, of course, is basically the dying star in mobile tech. Weird how things change.

RIMM and Apple is a great example of how awesome pairs trading can be. I’m waiting on RIMM to go bankrupt – the only thing of value in that company is its treasure trove of patents in this recent sea of tech legal battles. AAPL seems extremely cheap even at current prices, so long as you believe that you can predict the future for consumer tech. Personally, I won’t invest in consumer technology companies, but there are a lot of people (everyone, basically) who know way more than me about that kind of thing.

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Darwin April 5, 2012 at 12:03 pm

Oh, those 120/20 and 130/30 funds were such a disappointment! Apple’s been amazing; now the trick is figuring out who the next Apple is; never easy!

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Long-Term Returns April 5, 2012 at 11:10 am

“Pairs trades can be a great supplement to your investment portfolio if you’re just a passive investor or an active trader. ” Sorry, you are nowhere close to being a passive investor if you engage in this sort of thing.

A “pair trade” is two separate trades. The “pair” part of it is just mental accounting. You are making two separate trades. You have 25% chance of getting both right, 50% of getting one right and one wrong and 25% chance of getting both wrong. You will be paying commissions for four trades (2 buys and 2 sells), bid-ask spread for four trades, and taxes on any capital gains. Your expected result is net loss relative to the market or relative to combined returns of these two stocks.

So the odds of your making money relative to the market on any one such “pair” is somewhere in high 40s percent due to those additional costs. Let’s call it 48%. The more of these trades you make, the worse your odds get. How is advice to engage in this activity financial evolution for the masses? It may be a great outlet for your gambling urges, but that’s about it.

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Darwin April 5, 2012 at 12:09 pm

Your highbrow reply is all wrong. Here’s why:

“Sorry, you are nowhere close to being a passive investor if you engage in this sort of thing.” – the example I gave is from a 1 year chart. making a single trade a year isn’t passive enough for you? If your method is to say, buy an index ETF and hold, many would still view holding for a year as passive.

“You will be paying commissions for four trades (2 buys and 2 sells), bid-ask spread for four trades, and taxes on any capital gains. Your expected result is net loss relative to the market or relative to combined returns of these two stocks.” – All these downsides you just cited apply word for word to your vaunted passive investments. Let’s say you want to be as passive and low-cost as possible and buy nothing but SPY. You still pay a commission and a bid-ask spread.

“So the odds of your making money relative to the market on any one such “pair” is somewhere in high 40s percent due to those additional costs. Let’s call it 48%. The more of these trades you make, the worse your odds get. How is advice to engage in this activity financial evolution for the masses? It may be a great outlet for your gambling urges, but that’s about it.” – I don’t think you got the whole notion of the pairs trade. It’s not really about “beating the market” per se because by doing a pairs trade, you’ve essentially eliminated market risk, right? So, whatever volatility there is in the market is irrelevant. It is about generating alpha from picking the winners vs losers in a particular sector. And as far as trying to peg percentages, that’s like any investment. Hypothetically, there is always a “risk-adjusted” return, free market flows, market efficiency, etc. which is supposed to negate any positive or negative returns EVER (net commissions), right? But we all know that’s not how all our returns stack up. There are some winners and losers.

Evolution is about being ahead of trends and actively managing your finances, not being left behind.

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CultOfMoney April 7, 2012 at 1:51 am

The commission on 4 trades and a bid/ask spread shouldn’t materially affect any investments that you make. If they do, you probably don’t have enough money to invest, especially when you consider you’ll pay half for any normal trade. Pairs trades aren’t risk free, but the idea is you make them lower risk by going long the best company in an industry and short the worst. That way if they both trend in the same direction, you’re getting the difference.

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ShortRoadTo April 5, 2012 at 7:26 pm

I like to use options for pair trades. That way if I am on the wrong side of the pair, I don’t get killed. Imagine Buying RIMM and shorting AAPL!

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Value Indexer April 8, 2012 at 10:31 pm

For that to work, you’re still assuming that the stock you’re going long on in underpriced and the one you’re going short on is overpriced. While you reduce the risk of broad market moves that could affect otherwise good returns, you need to be twice as right compared to simply picking a single stock to buy or short. With an extreme result the one you’re long on can only go to 0 but the one you’re short on can lose you a lot more than you put in. Technology seems like an even more risky place to practice this since it’s an unpredictable industry.

To sum it up you could say I’m long holding indexes and short pair trading :) What have your results been so far doing this?

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