Trading Pairs

Trading Pairs
by Douglas S. Ehrman

Article Contributed by Active Trader Magazine

Pairs trading is a non-directional strategy that identifies two companies (or futures contracts) with similar characteristics whose price relationship is outside of its historical range. The strategy simply buys one instrument and sells the other in hopes that relationship moves back toward normal. The idea is the price relationship between two related instruments tends to fluctuate around its average in the short term, while remaining stable over the long term.

For example, the price relationship between Bank of America and U.S. Bancorp (BAC/USB) has remained relatively stable at a ratio of 1.5 over the past four years. During that period, its price ratio has been as high as 1.8 and as low as 1.35. The goal is to identify these stable relationships and buy the stock lagging the historical average and sell short the one leading it.

When trading pairs, you’re not concerned with how the individual stocks perform, but with their relative performance. As the market rises, both long and short stocks appreciate, so the pair’s overall value remains constant. Similarly, if the market declines, each stock drops. However, the pair profits as long as the long stock outperforms the short one.

Simply going long (or short) limits forecasting to a single direction, which means you can’t take advantage of the relative
values of all the instruments you track. Assume, for example, that you expect two stocks in the same industry to perform
much differently — one is expected to have a higher-than-average return and the other a lower-than-average return.

If you’re limited to going long, you’d buy the more attractive stock and ignore the one that’s expected to underperform.
In a pairs trade, however, you could enter a long position in the attractive stock and enter a short position in the less attractive one, which uses all available information and exploits the relative performance of both stocks.