Pairs trading is no longer a city secret Spread betting is all about having an edge, just like in poker! Pairs trading is one popular tactic. It’s when you go long on one share (bet that it will rise), and go short on another (bet that it will fall) in the same sector.
Pairs trading is, as you might expect from the name, betting on two different financial products at the same time. The idea is that two underlying products are in some way related, so you eliminate some element of chance compared to simply making a single bet.
When you put a long bet on one share, and an opposite short bet on another share in the same industry sector, you betting on the differences between the two securities. The idea is that since both shares are in the same sector, they’ll probably rise or fall together. But if one company is stronger than the other, the stronger company with get a higher price rise.
For instance, one form of pairs trading is to bet on different stocks from the same market sector. You look at their strength relative to the sector, and pick the best and the worst ones. You would buy the strong one, and sell the one with less relative strength. This works well in sectors such as commodities, oil and electricity.
See what you have now achieved. You have eliminated one variable in your betting. If the energy sector as a whole goes up or down, you don’t really mind. If the sector goes up, you expect that the one with greater strength will rise more than the weaker one. Similarly, if the sector goes down, you expect the weaker stock to go down more than the strong one. The overall state of the economy or of the market sector is not much of an issue, you are simply betting that you will come out on top by betting on the comparative merits of the two stocks.
Example
Imagine you like the subscription TV market. If we choose two different companies, Sky and Virgin Media. If we believe that Sky is the stronger company, we place an up bet on Sky, and a down bet on Virgin Media.
Scenario #1
The subscription TV sector gets a re-rating. Both shares go up. Shares in Sky go up 10% and Virgin Media go up 3%. The gain from Sky shares more than makes up for your losses in Virgin Media.
Scenario #2
The subscription TV sector gets a re-rating. Both shares go up. Shares in Sky go up 10% and Virgin Media go up 10%. You break even as a result.
Scenario #3
The subscription TV sector has a de-rating. Both shares go down. Shares in Sky fall by 10% while those in Virgin Media fall 15%. The money you make from the down bet on Virgin Media compensates for the loss on your Sky up bet. You see how pairs trading gives us two ways to win and one way to break-even? The goal in pairs trading is for one share to outperform the other, leading to profits.
Another way to pairs trade is to pick two related commodities, such as gold and silver, and look at how their relationship has progressed, and whether there is a current imbalance that can be exploited. You need to be mindful of whether a “correction” is likely soon, by looking at the technical analysis, but the principle is that the prices will move back in line with each other over time, and you bet appropriately. Again, what you have done is eliminate the unknown of whether the government will issue more money, or public confidence will change, devaluing the currency or in other words increasing the cost of precious metals; or the opposite, that gold and silver are not so prized because the economy is looking good.