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Pairs trades can help limit the impact of market risk

by Nick Sudbury

The main difficulty with trading in news-sensitive markets is almost any announcement has the potential to spark a major rerating across the board. This has the effect of rendering open positions vulnerable to seemingly unrelated events. One of the best ways to protect against this is to eliminate the market risk by using a pairs trade. This involves identifying two shares in the same sector, which generally move in tandem but have temporarily diverged. The idea is to exploit the anticipated convergence of these prices by going short the leader and long the laggard. By matching the sizes of each leg of the trade, the combined position becomes market and sector neutral.

‘In a pairs trade the investor is not taking a view on the direction of the stocks in absolute terms, but on the direction of the stocks relative to each other,’ says Kareem Khouri, managing director at the CFD advisory broker Killik Capital. ‘For instance, if the market as a whole has a dramatic fall and both of the stocks held move in line with it, the investor should experience a gain on the short and a similarly sized loss on the long position, leaving the overall profit close to break-even.’

Any doubt about the potential of pairs trading has surely been dispelled by the performance of the BlackRock UK Absolute Alpha fund. This has achieved positive returns in every quarter since it was first launched more than three years ago and in each month since the emergence of the credit crisis last July. The consistency is down to the fact that the managers routinely invest at least 40% of their portfolio in pairs trades, which they achieve by combining shareholdings with short CFDs.

Josh Raymond, market strategist at City Index, says people can use pairs trades on either a technical or a fundamental basis. ‘Trades based on the fundamentals can be more lucrative, but it is important to choose the right sector as the strategy relies on spotting two shares that have diverged and will quickly converge again.’

Lately, such divergence/convergence has been more evident among mining and oil stocks than it has in areas such as the banks.

‘Traders should look for pairs of stocks with strong long-term correlations as this lowers the risk, with the big players in the sector normally being the best option,’ says Raymond. ‘Examples include General Motors/Ford in the US and BP/Shell in the UK.’

The risk-reduction benefit depends on the securities being traded: the higher the correlation, the better the effect. An active investor who regularly places pairs trades may also be able to gain a secondary advantage by negotiating a reduction in the initial margin requirement from the broker.

Many pairs trades are implemented following news that temporarily knocks the two shares out of sync. A similar situation applies when companies in the same sector bring out their results on different days, the hope being one stock will outperform the other. This was an option on BP (BP.) and Royal Dutch Shell (RDSB), with the former announcing its second-quarter figures on 29 July and the latter following suit two days later.

‘Pairs trading is not a 100% winning strategy but those who do their research well can find it quite lucrative,’ says Raymond. ‘In order to control the risks it is important to always use stop losses and to manage the position, so if one leg is stopped out the investor can intervene to close the other.’

Pairs trading is a good objective strategy but requires a strong nerve as it entails buying weakness and selling strength. Using stops is generally a sensible precaution, but they can destroy the performance because in theory if someone trades on a divergence any increase should represent a better opportunity. The answer is for people to be rational with their capital and not trade too big too quickly.

Technical pairs trade

On 7 August, Killik Capital issued a trade alert to clients to go long Unilever (ULVR) and short Reckitt Benckiser (RB.). The thinking was Unilever had markedly underperformed Reckitt Benckiser over the previous month and a situation had developed where the former was technically oversold and the latter technically overbought.

‘At the same time there seemed to be a stabilisation on the relative chart, hinting that a reversal in relative performance could be about to take place,’ says Kareem Khouri. ‘Other technical indicators supporting the trade were the bullish move in the MACD histogram in Unilever, and the extreme reading on the MACD histogram for Reckitt Benckiser, which hinted that the price acceleration in the stock may have reached a top.’

To take advantage of the expected reversal in relative performance the firm advised clients to short Reckitt Benckiser at £27.65, with a stop at £28.80 and a plan to take profits at £25.10. The other leg of the pairs trade was to go long Unilever at £14.45, with the stop at £13.30 and the target profit at £16.15.

An important point when placing a pairs trade is that the long and short positions both need to equate to the same monetary exposure if the combination is to be market neutral. For example, with Unilever and Reckitt Benckiser trading respectively at £14.45 and £27.65, a £10,000 position in each would mean going long in 692 CFDs of the former and short in 362 CFDs of the latter.

Matching the monetary values of the two trades also has the added advantage that the pairs position can be monitored purely by the ratio of the two share prices, with any decrease in the ratio of the short price to the long price indicating the combined position was in profit.

Fundamental view

Rainer Gerdau, an equity strategist at Saxo Bank, says pairs trading can be used to exploit a strong view of a share, sector or market. ‘A pairs trade based on the fundamentals could last for several weeks or even months. These sorts of positions allow for bigger profit targets than a purely technical trade, though it does mean moving the stop losses wider, which is why it is important not to over-leverage the exposure.’

For example, Saxo Bank recently shorted Volkswagen against a combined long position in Renault and Fiat. The thinking was Porsche’s takeover bid for VW had left the company trading at double the average sector valuation, while Renault and Fiat were two of the cheapest constituents.

‘A technically based pairs trade might last for two or three days but the tighter targets and high volatility make it difficult to use stop losses, which means it is essential to watch the screen the whole time in order to manage the position,’ says Gerdau. ‘Even those who pick the right stocks can find it difficult, as a sector could easily move as much as 5% overnight, with the shares opening the next day 10% off their previous close.’

Altan Ali, a director at advisory CFD broker Central Markets, says pairs trading is more widely used by hedge funds and professionals than by private clients, which the latter should note. ‘The key point as far as pairs trading is concerned is it is generally far easier to make a call on the relationship between two markets than the direction of one market outright.’

One example Central Markets has used recently is to go long British Airways (BAY) and short easyJet (EZJ). Both have been hit by high fuel costs and the poor economic outlook, but the latter has been more vulnerable due to its smaller profit margins. ‘British Airways and easyJet are both suffering the effects of the rise in fuel costs, but as can be seen on the relative chart, it is easyJet that is hurting more than the flag carrier,’ says Ali.

Variations

A pairs trade does not necessarily have to involve two equity CFDs. Perhaps the most common variation is a long/short combination of different stock market indices, or running a sector index against the wider market as a whole. These are sometimes referred to as spread trades, with the idea being to capitalise on the relative performance.

A topical example would be to short the airlines sector while going long the FTSE 100 index. The idea behind this would be to profit from the relative weakness of airline stocks, while taking less risk than an outright short.

‘The advantage of a pairs trade involving a sector index against the wider market is it allows someone to take a strong view of the sector while eliminating the market risk,’ says Gerdau. ‘At Saxo Bank we have been short the UK housing sector since March while going long the FTSE 100, as we believe the property situation in the UK will be similar to that in the US.’

The most common example of a pairs trade comprising two market indices is the S&P 500 against the Dow. Both are highly correlated with the former offering more of a mid-cap exposure than the latter.