Introduction to Pair Trading in Stocks and ETFs for Beginners

In professional terms Pair trading is also known as convergence trading strategy and statistical arbitrage.

Candidates for a perfect pair can be spotted when correlation in two stocks weakens and one heads higher where as the other takes a knock down. But these have to be from same sector for the pair trade to carry minimal risks.

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There is no doubt that stock market always remains unpredictable.  This makes it difficult for market participants to decide whether to invest long or sell short. So you should have a proper strategy before diving into trading and investing arena. Some traders without strategy often find themselves losing money at a great pace.

What is Pair Trading?

Pair trading is a strategy, which help to reduce portfolio volatility and make money in volatile environment. With the help of the pair trading strategy, we can hedge a long position of one stock with the short position in another. Investors utilizing this strategy usually go long on a stock that they feel has a fair chance of outperforming the markets and pair this with a short trade in a peer stock which is showing signs of weakness or underperformance. The aim is to have profits from one side of the transaction offset losses from other trade. Many people use individual stocks in pair trading but there are other better ways to utilize this strategy.

Intra-Sector ETF Pairs Trade

ETFs are becoming very popular over the years. There are several ETFs in a particular sector. The ETFs focusing on a particular sector may have similar names. However, they are different from one another. They are different in terms of stocks they invest in and their investment returns.

Intra-sector pair’s trades such as this one are the least popular type of trade. While ETFs in the same sector might experience dissimilar performance over a given period, the opportunities for success are limited because the difference is likely to be narrower than it would be for pair’s trades that use ETFs from different sectors.

Instead of focusing on ETFs that invest in the same sector, this strategy matches different ones to create a true portfolio hedge. In order to do this, an investor would be long the sector or sectors that have the best outlook and short the sectors with a subdued performance outlook.

The months October through the middle of May 2008, IDU lost 1% and VFH fell 24%. The hedge was not perfect because IDU did not move higher, but shorting the financial sector ETF made the trade very profitable. The net profit of 23% was much better than the 9% loss of the S&P 500 in the same period.

Every year money flows in and out of the varying asset classes. Initially, the trend of the early 2000s involved the small-cap stocks beating the large caps. Typically, one asset class does not stay on top for more than a few years before falling to the bottom as the investing cycle progresses. Investors with the help of ETF pairs trading can play with the future flow of money between asset classes can exploit this pattern with index.

Conclusion

It has been seen that the timings of the pair trading is critical. The hedging aspect of the strategy reduces the risk factors. An investor should be completely certain about new long ETF position in order to venture in the market.

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