Pairs Trading with Exchange-Traded Products

An ETP can be a useful tool when paired up with a stock in a long/short trade

Morningstar ETF Analysts 28 January, 2011 | 10:32AM
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Pairs trading is a trading strategy in which two securities that are very similar in most aspects, but differ in one key aspect, are traded against each other in a long-short fashion. By going long one security and shorting the other, you eliminate most risks save for the one you wish to exploit. This article discusses the strategy and how it might be made easier by employing exchange-traded products (ETPs).

In the stock market there is no sure thing. Even if you are very confident about an investment idea, some unforeseen event could turn the tables on you. Pairs trading attempts to control outside risks--chiefly market risk--allowing you to focus on just one at a time. For example, let's say that you are a fan of Apple (AAPL) products and when the iPad was released you anticipated that it would steal e-book reader market share from Amazon.com's (AMZN) Kindle. Using a pairs trade you could have bought shares in Apple and sold short shares of Amazon. Two months after the release of the iPad, shares in Apple were up about 7% while shares in Amazon were down 5%.

Pairs trading can reduce market risk, but it can increase single-security risk. For example, let's say that you witnessed the success of the iPod and how it changed the way people listen to music. Perhaps back in the summer of 2008 you thought that the new version of the iPhone would be a similar success and continue to steal market share from other smartphones such as Research in Motion's (RIMM) BlackBerry. If you bought shares of Apple in June 2008 you would have lost money for at least a year despite the fact that your investment thesis was correct. Apple shares decreased about 20% from June 2008 to June 2009, as the broader market--represented by the S&P 500--decreased about 30%. However, if you had used a simple 1-for-1 pairs trade, simultaneously buying Apple and shorting Research in Motion, you would have netted a positive 20% because Research in Motion decreased 40%, twice Apple's 20% loss.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.