Today I’ll show you how to make money, whether the market trades up or down, with a simple-yet-effective strategy that the hedge funds use: pairs trading.
Many of you might already be familiar with this strategy. But even if you are, keep reading to check out the spin that you can put on it to make it even more effective than most professionals do.
Profit Regardless of the Market’s Direction
Pairs trading allows you to position yourself to make money, even when you’re wrong about the direction of the stock market. It involves considering two separate positions as one position.
First, you find the stock or exchange-traded fund (ETF) that you think has the greatest chance of advancing, and you bet on it doing just that. Then you find another one that you think has the greatest chance of declining, and you bet on it doing so. Again, the combined trades should be considered as a single position.
As you probably know, you can profit from a downward move in a stock or ETF by selling short that security. You sell it at one price, and then try to buy it back cheaper, profiting on the difference. There are many other ways to profit from a downward move, but short selling is the most popular. (Learn how to Play it Safer With Put Options.)
Now, you’ve probably heard the old saying: “A rising tide lifts all boats,” meaning when the general stock market advances, even crummy stocks trade up. On the flip side, when the general market gets slammed, even great stocks move lower.
However, in down markets, strong stocks and ETFs tend to trade down by a lesser amount than weak stocks and ETFs. And, in up markets, strong stocks and ETFs tend to trade up by a larger amount than weak stocks and ETFs.
Everyone understands the concept of diversifying their portfolio for safety. The traditional way of diversifying assumes the market only trades up. When some of your stocks inevitably go down, you have others that go up, and hopefully the advancing positions outweigh the declining ones. Either way, you are playing it safe. That is, unless the market tanks.
Well, pairs trading is one way of diversifying, but it shields you from having to guess the direction of the stock market.
You make two bets — a bullish bet on one stock or ETF and a bearish bet on another. If everything works perfectly, your bullish bet trades higher, and your bearish bet trades lower, so both parts of the trade win!
But since the stock market has a lot to do with the direction of your positions, it’s likely that a strong up or strong down market will cause you to be right about one part of the position, and wrong about the other.
If the general stock market moves up by 20%, and your bullish trade advances 50% while your bearish trade advances 20% (which is essentially a 20% loss to you), your combined position is up 30%.
Pairs Trading With Stocks
Editor’s note: This article was originally published on June 10, 2008.
Let’s say you read my April 1, 2008 article titled “How to Make Sure YOU Don’t Own the Next Bear Stearns,” and my comments on Lehman Brothers prompted you to bet that the stock would trade lower. At the same time, you decided that, since energy stocks were doing well, you’d bet that Exxon Mobil (XOM) would trade higher.
Two weeks later, you bought $10,000 worth of Exxon and you sold short $10,000 worth of Lehman Brothers. You consider the two positions as one, so you essentially have a $20,000 position.
Lehman Brothers traded from $45 to $29.43 — down 35% — which is in your favor.
Exxon Mobil traded from $93.50 to $89.08 — down 5% — which is not in your favor.
You were right about your bet on Lehman Brothers trading lower, but you were wrong about Exxon Mobil trading higher. Together, the combined position shows a 15% gain: (35% gain – 5% loss = 30% gain)/2 = 15% average/combined return.
In this case, the general market basically traded flat. The strategy isn’t really put to the test here because the market was flat. But it illustrates how we were wrong on XOM but profitable on the whole deal.
But here’s the important takeaway: Since Exxon Mobil was a stronger stock than Lehman Brothers, we can assume that if the market pushed higher, Lehman would either still have declined, or it would have been pushed up by the market, but by a lesser percentage gain than Exxon. That would be a win.
Pairs Trading With ETFs
Now let’s make it interesting. Let’s say you read my Jan. 3, 2008 article titled “Crude Oil Hits $100! 3 Ways to Profit From It!” and you gathered from that read that you could profit from an advance in the energy sector and a decline in the airline sector.
So you took my advice and took a bullish position on the ETF representing energy stocks, the Energy Select Sector SPDR (XLE), and a bearish position on the airline index, the NYSE Arca Airline Index (XAL). Since XAL is an index (not an ETF), you would buy put options on it.
If you used pairs trading and committed the same dollar amount to each of the positions, you would have made a killing, and you would have been hedged.
By the stock market’s March 2008 low, the energy ETF that we were bullish on was down 10%, and the airline index that we were bearish on was down 30% (which means a 30% gain). The combined positions show a net gain of 10%.
$10,000 bullish in XLE was down $1,000 (10%)
$10,000 bearish in XAL was up $3,000 (30%)
Net gain on $20,000 is $2,000 (10%)
At the same time, the S&P 500 had declined by 12%.
My Spin on Pairs Trading
My spin on pairs trading is simple. Trading deep in-the-money options (high delta options) in replacement of stock gives you an even better reward-to-risk ratio.
Here’s a hypothetical example:
If XYZ stock trades up 10 points, the deep in-the-money (high delta) call option may trade up 9 points.
If XYZ stock trades down 10 points, the deep in-the-money (high delta) call option may only trade down 7 points.
What does that tell you?
First, consider what happens in pairs trading when the bullish stock gains 10% and the bearish position loses 10%. You would be flat, right?
Well, if you replaced your bullish stock position with high delta calls, and your bearish position with high delta puts, here’s what happens in the hypothetical example above:
Your call option (assuming it’s on a $100 stock) gains 9 points.
Your put option (assuming it’s on a $100 stock) loses 7 points.
That’s a net gain! Sure it’s only 1% in this simple example, but it can be magnified in many circumstances.
Chris Rowe is the Chief Investment Officer for Tycoon Publishing’s The Trend Rider. To learn more about him, read his bio.
