What is Pairs Trading?

Pairs trading sometimes also known as a hedge trade, involving going both long and short on two shares with in the same sector. The theoretical backdrop for this is if both shares are within the same sector they will both move in the same direction. But if one company is believed to be stronger you would expect this share perform better than the weaker company.

An example of a Pairs Trade would be taking a long position on Rich Oil Drilling, while taking a short on a similar but poorer performing Speculative Oil Drilling. Suppose both shares were trading at 100p at the time you placed your original order. If the sector performed well, an outcome might be that Rich Oil Drilling rises to 110p, making a 10 point profit. While your short side Speculative Oil Drilling made only 105p only making a 5 loss. Overall you will come out on top, even though you lost on one side of the trade.

The benefit is that you would expect a profit if the sector began to move against you as you would expect the better company to make less of a loss than the company you shorted. Pairs Trading allows you to hedge your risk often very effectively. But there are also potential pitfalls with such a strategy, to make a successful Pairs Trade you need to make sure that each the performance of each company is correlated with each other. You also need to establish which represents the strongest company out of the pair which is a task that is much more difficult than it might sound at first. 

Pairs trading can also been undertaken in a different way, a pairs trade can be undertaken on companies from different sectors for example one from a cyclical sector and another stock from a sector that is safe from cyclical concerns. An example of such a pairs trade might be pairing a utility with a retail sector stock.

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