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:
- 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
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?