Richard Avery-Wright

Market Neutral or Pairs Trading is a strategy designed to benefit traders in all market conditions. Whether the market goes up, down, or sideways, the strategy has a higher probability of generating profitable results whilst generally employing lower risk. It is one of the most popular strategies employed by hedge funds and, via the use of equity CFDs, it is increasingly being used by other market professionals and traders.

Simply put, a market neutral position (or Pairs Trade) is established by the simultaneous purchase and sale, on a money-for-money basis, of two highly correlated instruments, such as equity CFDs, in the same sector. Correlation is a statistical co-efficient that measures the strength of the relationship between two variables. Typically, high-probability Pairs are big stocks in the same industry with similar long-term trading histories.

Implementing the strategy means finding a pair of stocks or instruments which are highly correlated on a long, medium and short-term basis (depending on profit objectives and risk tolerance), and buying (going long) one stock and simultaneously selling short another. There are no hard and fast rules but typically divergence from the mean of around 5-7% will be sufficient to initiate a Pairs trade. Once a Pairs Trade has been established, the trader is not concerned with the direction of the share price movement, but only whether or not the Pair positively correlates by reverting to the mean of the previous interrelationship of price.

Hedge Funds and other market participants will obviously use a variety of methods in determining whether or not to enter into a Pairs Trade. Some managers, for example, will use proprietary screening models to search for suitable Pairs. Once a universe of Pairs is established the manager will perform a number of quantitative (and sometime qualitative) tests to seek out the best candidates.

For the retail investor, perhaps the best way to identify and monitor Pairs Trades is via the ratio. For example, ANZ and Westpac are currently priced at $29.80 and $29.05 respectively. Dividing the ANZ share price by the Westpac share price gives a current ratio of 1.0258 ($29.80/$29.05). To view the ratio over time, the best tool to use is a ratio chart. A ratio chart gives the trader a feel for historical volatility within the ratio and also a perspective of whether the Pair is typically mean reverting. An ideal ratio chart should resemble a wave formation with no out performance of one share over another in the long term, but with sufficient height to be able to provide trading opportunities. Of course, corporate actions such as dividends may distort the ratio, so it is recommended that traders do their due diligence prior to the initiation of a Pairs Trade.

Advantages:

In an ideal situation, profit on the price movements can be made on both legs of the trade (see below).

A Pairs Trade can remove market risk. By taking a simultaneous long and short position, a Pairs Trader is only concerned with the relative performance of the trade.

This strategy enables the trader to utilise intimate knowledge of a sector and maximise profit by selling the overvalued stock and buying the undervalued stock.

Disadvantages:

Utilising Pairs Trading strategies is more capital intensive than directional CFD trading as it requires the trader to put up initial margin in respect of both the long and short positions of the Pairs Trade.

Traders are more sensitive to transactional costs as each transaction requires a minimum of four trades to establish and close the Pair. Using a Direct Market Access(DMA) CFD provider, where you do not necessarily have to cross the bid/ask spread, will greatly help to reduce frictional costs such as slippage.

Of course, it should be noted that risk reduction will also reduce profit potential. And some times poor timing of entry into, or further divergence between the Pair, can lead to a loss on the position. One way around this is to scale into the trade at certain incremental levels to allow some flexibility in unwinding the trade. However, there has to be a point at which the loss must be acknowledged when a historically correlated Pairs Trade breaks down.

Case Study: ANZ/WBC Pairs Trade

Date: 19/10/2007

SELL 3247 ANZ Bank (ANZ) at $30.80

BUY 3472 Westpac Bank (WBC) at $28.80

Trade established at a ratio of 1.07($30.80/$28.80), contract value $100,000 per leg (requiring initial margin of $5,000 per leg ($100,000 X 5%).

Date: 26/10/2007

BUY 3247 ANZ Bank (ANZ) at $29.80

SELL 3472 Westpac Bank (WBC) at $29.30

Trade closed at a ratio of 1.02 ($29.80/$29.30)

Profit and Loss

Profit on ANZ = 3247*($30.80 - $29.80) = $3,247.00

Profit on WBC = 3472*(29.30 - $28.80) = $1,736.00

Overall profit = $4,983 (does not include costs associated with the trade, such as commission and financing spreads).

Return on capital employed as initial margin = $4,983/ (2*$5,000)*100 = 49.80%

In this example, although both stocks moved in the opposite direction, this is unusual. In general, as the whole purpose of trading in this manner is to pick highly correlated pairs in the same sector, it is more usual for the pair to move in the same direction – profit is achieved via your chosen long or short stock out-performing the other paired stock.

Richard Avery-Wright

Disclaimers: The views expressed in this article are those of Richard Avery-Wright and is not intended as general advice. This does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.