There are many different types of pairs trading. But when
it comes to stocks, it typically means taking a long
position in one company's stock against a short position in
another company's shares. The purpose is to capitalize on
diverging performance, while reducing exposure to the broad
market.
Benefits: When an investor implements a pair trade, he is making a bet on the relative performance of one asset vs. another. As a result, the combined return of the pair trade can have little or no correlation with the broad market, hence it can be a great diversification tool. Unfortunately, investors are often told by their advisors they must hold many stocks to diversify their portfolios. While this is true, this strategy is not perfect. Why? Most advisors do not mention that in a bear market (when diversification is needed the most), your stocks are all highly correlated, i.e. they often all decline in value.
The chart below demonstrates how several popular stocks from different sectors all fell together in the current bear market. Below, we demonstrate how stocks from different sectors in order to prove that even when portfolios are diversified, you can still loose money.
Ideally, portfolios should consist of stocks that don't always decline at the same time (i.e. the portfolio contains shares that have a low correlation with each other, even during broad market bear phases). Unfortunately, this is not easy to achieve, yet one solution is including pair trades in your portfolio.
A Pair Trade Example
As mentioned at the beginning of this article, pair trades can achieve the diversification that long-only portfolios often cannot. We are fans of intra-sector pair trades. For example, candidates for an intra-services sector pair trade would be going long Comcast Corporation (ticker: CMCSA) and short Best Buy (ticker: BBY). This pair trade would help to hedge sector-risk and market-risk. For example, if the overall market were to crash along with the services sector, it would be safe to assume that both stocks would probably decrease in value as well. However, the short BBY position will make money, which will most likely negate the loss on the long CMCSA position (we provide evidence based on our jugement supporting this thesis below).
The chart below shows the relative performance of CMCSA vs. BBY. This is calculated by simply dividing CMCSA by BBY stock prices. When this ratio rises, CMCSA is outperforming BBY and vise versa. Notice how the pair trade ratio is independent of the S&P 500's movements. In fact, since 2000 the pair trade has had a -0.16 correlation with the market, which is pretty low.
Our basis for liking this pair trade: The U.S. economy is on the brink of a recession and as a result, consumers are watching how they spend their money. History shows us that consumers have not been quick to cancel their cable subscriptions during past economic downturns. This suggests that Comcast's earnings will not slow too much. However, it is more likely that consumers will postpone buying a new television set or computer, as these expenses are usually larger, which is a scary thought for electronics stores such as Best Buy. Even if we're wrong, and the number of cable subscribers that cancel their subscriptions rises compared to past recessions, it is doubtful that Comcast will lose more business than a company like Best Buy (i.e. if people are canceling cable subscriptions because they cannot afford them, chances are they are not buying new televisions either).
In order to complete our analysis and justification for this trade, it is important to make sure that Comcast's financial health is much stronger than Best Buy's and its stock has stronger chances of outperforming Best Buy, based on each firm's financial condition. To quickly accomplish this, we use Super Stock Screener's Ranking System. This Ranking System has a solid track record of recommending stocks that have outperformed the overall market and warned of those that will underperform and possibly crash. For more information about the Ranking System, please visit our Ranking System's methodology page. As of this September, Comcast is ranked as a "Strong Buy", while Best Buy is ranked as a "Sell".
Finally, Comcast's stock valuation is more attractive. Comcast's price-to-book ratio is just 1.53, while Best Buy's is 3.98.
Therefore, using common sense we have found a promissing pair trade candidate (Comcast vs. Best Buy) for the current macroeconomic environment. Our long candidate (Comcast) has a better business outlook than our short candidate (Best Buy), it is in much stronger financial health (according to Super Stock Screener's Ranking System) and its price-to- book multiple is more attractive.
Risks
Just like any other stock-based investment, pair trades can lose money. Essentially, if your bet is incorrect (i.e. if Comcast underperforms Best Buy in our example), then the pair trade will lose money.
Conclusion
Trading pairs is not a risk-free strategy. Therefore we highly recommend including them as an add-on to your long- only stock portfolios. For example, investor's stock portfolios could consist of 70% long stock positions and 30% pair trades. Owning pair trades will help reduce your overall exposure to the broad market, and as a result, when the overall market declines, part of your portfolio will be hedged.
Happy trading.
Benefits: When an investor implements a pair trade, he is making a bet on the relative performance of one asset vs. another. As a result, the combined return of the pair trade can have little or no correlation with the broad market, hence it can be a great diversification tool. Unfortunately, investors are often told by their advisors they must hold many stocks to diversify their portfolios. While this is true, this strategy is not perfect. Why? Most advisors do not mention that in a bear market (when diversification is needed the most), your stocks are all highly correlated, i.e. they often all decline in value.
The chart below demonstrates how several popular stocks from different sectors all fell together in the current bear market. Below, we demonstrate how stocks from different sectors in order to prove that even when portfolios are diversified, you can still loose money.
Ideally, portfolios should consist of stocks that don't always decline at the same time (i.e. the portfolio contains shares that have a low correlation with each other, even during broad market bear phases). Unfortunately, this is not easy to achieve, yet one solution is including pair trades in your portfolio.
A Pair Trade Example
As mentioned at the beginning of this article, pair trades can achieve the diversification that long-only portfolios often cannot. We are fans of intra-sector pair trades. For example, candidates for an intra-services sector pair trade would be going long Comcast Corporation (ticker: CMCSA) and short Best Buy (ticker: BBY). This pair trade would help to hedge sector-risk and market-risk. For example, if the overall market were to crash along with the services sector, it would be safe to assume that both stocks would probably decrease in value as well. However, the short BBY position will make money, which will most likely negate the loss on the long CMCSA position (we provide evidence based on our jugement supporting this thesis below).
The chart below shows the relative performance of CMCSA vs. BBY. This is calculated by simply dividing CMCSA by BBY stock prices. When this ratio rises, CMCSA is outperforming BBY and vise versa. Notice how the pair trade ratio is independent of the S&P 500's movements. In fact, since 2000 the pair trade has had a -0.16 correlation with the market, which is pretty low.
Our basis for liking this pair trade: The U.S. economy is on the brink of a recession and as a result, consumers are watching how they spend their money. History shows us that consumers have not been quick to cancel their cable subscriptions during past economic downturns. This suggests that Comcast's earnings will not slow too much. However, it is more likely that consumers will postpone buying a new television set or computer, as these expenses are usually larger, which is a scary thought for electronics stores such as Best Buy. Even if we're wrong, and the number of cable subscribers that cancel their subscriptions rises compared to past recessions, it is doubtful that Comcast will lose more business than a company like Best Buy (i.e. if people are canceling cable subscriptions because they cannot afford them, chances are they are not buying new televisions either).
In order to complete our analysis and justification for this trade, it is important to make sure that Comcast's financial health is much stronger than Best Buy's and its stock has stronger chances of outperforming Best Buy, based on each firm's financial condition. To quickly accomplish this, we use Super Stock Screener's Ranking System. This Ranking System has a solid track record of recommending stocks that have outperformed the overall market and warned of those that will underperform and possibly crash. For more information about the Ranking System, please visit our Ranking System's methodology page. As of this September, Comcast is ranked as a "Strong Buy", while Best Buy is ranked as a "Sell".
Finally, Comcast's stock valuation is more attractive. Comcast's price-to-book ratio is just 1.53, while Best Buy's is 3.98.
Therefore, using common sense we have found a promissing pair trade candidate (Comcast vs. Best Buy) for the current macroeconomic environment. Our long candidate (Comcast) has a better business outlook than our short candidate (Best Buy), it is in much stronger financial health (according to Super Stock Screener's Ranking System) and its price-to- book multiple is more attractive.
Risks
Just like any other stock-based investment, pair trades can lose money. Essentially, if your bet is incorrect (i.e. if Comcast underperforms Best Buy in our example), then the pair trade will lose money.
Conclusion
Trading pairs is not a risk-free strategy. Therefore we highly recommend including them as an add-on to your long- only stock portfolios. For example, investor's stock portfolios could consist of 70% long stock positions and 30% pair trades. Owning pair trades will help reduce your overall exposure to the broad market, and as a result, when the overall market declines, part of your portfolio will be hedged.
Happy trading.
