The next time you decide to buy a stock why not consider selling one from the same sector as well?

The strategy known as pairs trading has the potential to increase returns without being dependent on the direction of the market. Used by institutions, hedge funds and investment banks for over two decades, it remains surprisingly underutilised by the average investor.

I like trading pairs on the ASX and today one of our readers sent me a Pairs Trading Tool, The Catalyst Corner Pair Tool is a proprietary tool offered FREE to their members. Members can create and customize their own security by entering individual stocks as long and short positions.

The Pair Tool automatically compares fundamental data while displaying graphically historical trading relationships between any two US publicly traded securities a member selects. TRY IT OUT

All about relative performance

Pairs trading is about betting on the relative performance of two related instruments. It requires buying one and short selling the other.

A pairs trade involving stocks means buying the stock you like and short selling the stock you don’t, with both stocks usually from the same sector and in equal dollar amounts. Most investors routinely do the first leg, not the second.

Adding a short sale makes sense for a number of reasons. It reduces your exposure to the market rising or falling (a good thing) and where you believe the short sale will make money in its own right, increase returns.

It does however add stock specific risk because you have two bets rather than just one. This costs money if your short sale loses more than your long (buy) makes. And the worst case scenario – you could lose on both legs. So the message is, spend some time really deciding on your buy and sell decision.

Intermarket pairs

The logic of pairs trading is to make money on the price difference or spread between any instruments. Although it’s common to buy and sell a stock pair there is nothing stopping you buying a stock / selling a currency, or buying a stock / selling a commodity.

The thing to remember is you want one leg to provide a degree of offset (negative correlation). Buying Lihir Gold (ASX: LGL) and selling gold (XAU/USD) works because you can expect one to profit when the other doesn’t.

If gold falls you could expect Lihir Gold to fall as well, with your short position in gold offsetting the loss. The aim is to close out when the combined value of both trades is positive.

Some more examples.
Coles (ASX: WES) v. Woolworths (ASX: WOW)

Suppose you thought it inevitable that Coles would gain ground on Woolworths. You reason that Wesfarmers’ success with Bunnings and a new management team would see the wide difference in financial performance between the two narrow. Not overnight, but within say 6 – 12 months.

Other considerations might include looking at financial ratios, same store sales figures over several quarters, sales per square metre, sales per employee and other retail metrics. Earnings forecasts, analyst upgrades/ downgrades, management changes, even a visit to your local Coles and Woolies might all be part of your due diligence. And your conclusion; buy Coles, sell Woolworths.

The difference between the two was approximately 25% by January and almost 30% in early March. On a $25K each way bet the return – had you gone the right way and bought Coles (ASX:WES) and sold Woolworths(ASX :WOW) was at one point $7.5K.

That’s a 20 % gain on your $25K position in Coles(ASX:WES) and a 10% gain on your $25K short position in Woolworths(ASX :WOW).

Dividends, Interest & Margins

Dividends and interest paid and received throughout the trade buy don’t really amount to much. On one side of the ledger you pay interest and are entitled to dividends. On the other you receive interest on your short sale but pay dividends. If trading through a CFD provider, this is all handled seamlessly.

Margins on the other hand are not to be dismissed. Margins amounts move up and down depending on whether you are making money (margin down) or losing money (margin up). In this example, margin would never have been an issue because the pair worked in our favour. Things aren’t always so smooth.

Cutting your losses if the pair moves against you because your call was wrong is part of speculating. Ignore this basic rule and you might run out of capital.

The next two charts highlight just how much two stocks from the same sector can diverge over 6 months.
BHP Billiton (ASX: BHP) v. Rio Tinto (ASX: RIO)
6 Month Chart – see chart gallery at bottom of page
Westpac (ASX: WBC) v. National Australia Bank (ASX: NAB)
6 Month Chart – see chart gallery at bottom of page

The best pair idea for next 6 months
Virgin Blue (ASX VBA) v. Qantas (ASX:QAN). This one could see a reversal of fortunes as Virgin Blue has been on a tear outperforming Qantas by a staggering 70% over the last 6 months.

Granted Qantas is losing market shares to discount carriers, replacing expensive seats with more in economy and is a “bigger bird” to turn around, but the pairs trade is all about relative performance. And they have their own discount carrier in Jetstar so don’t expect them to give up without a fight.

Elizabeth Tilley is with the Finance News Network in Sydney

Posted by Shayne Heffernan on Jul 2nd, 2010and filed underAsia, Equities, Latest News, Limelight, Markets.You can follow any responses to this entry through theRSS 2.0You can leave a response by filling following comment form or trackback to this entry from your site