Pair Trade Basics
Research for Online Investors

This article originally ran on 1/29/10 in MarketToday

You may have heard someone speak of a “pair trade” and not known what people are talking about. Let’s look at some ideas for a pair trade, to understand the value of this technique.

Pair trades require a different way of looking at the market. We are used to buying a stock that we think will go up. We see a company or commodity that is undervalued, or perhaps we expect a new product or service to increase revenue and drive higher profits in the future. This defines much of our search for new investment opportunities.

What if we think about trends that will occur in the future? These can be short or long term trends, based on your investment horizon. Once we identify a trend we believe will occur, it comes naturally to understand who will benefit from that trend. What sector or company stands to profit? The next step is sometimes harder, what sector or company will be adversely impacted by the trend we have identified?

What you have done is pictured the future, and identified the winners and losers. Now you have a pair trade. Buy the winner and short the loser. If you are correct in your trend the winner will report larger profits which will be reflected in a higher stock price, the loser will be adversely impacted and the stock will suffer. You make money on both sides of the pair trade.

The strength of the pair trade comes in though if you are wrong. If your trend does not occur, then what happens to your long and short companies? All things being equal, both trade with the market, offsetting the other and you neither make nor lose money. You stood a chance to make a great return, with a risk of almost zero. You close out both positions, and move to your next idea.

How about an example from history that makes a pair trade perfectly clear? At the turn of the century, automobiles were just starting to be accepted for use as transportation. If you correctly identified the trend you would buy Chevrolet and short harness makers. The automobile stock would double and triple in value, while the harness makers were going out of business. If you were wrong that automobiles would take over transportation replacing horse and buggies, both businesses would continue without affecting the other, giving you the chance to close the trade without a loss.

The second kind of pair trade used by many traders is based off of cost disparity. For example, we know that if a raw material is priced at $x.xx then the finished product has to cost $x.xx + finishing cost. If copper is $3.00 per pound then copper wire must cost $3.00 per pound plus the cost of manufacture. Traders can sometimes catch a market disparity and profit from the return to pricing normalcy. Either the raw material cost must go down or the finished product must increase in price. Go long the finished product and short the raw material. One or both positions should move to restore the price relationship.

There is a third pair trade used when historical averages are stretched to extremes. A good example of this is the cost of gold (real money) to the cost of oil (energy). Historically, over the last 20 years, it has taken about 11 barrels of oil to buy one ounce of gold. If oil costs $75 a barrel the gold should cost about $825 per ounce. In the following graph we can see June and July of 2008 when oil was $140 per barrel and gold was $900 per ounce. The ratio was 6.5 It only took 6.5 barrels of oil to buy one ounce of gold!

By January 2009 the ratio swung to another extreme with oil at $40 per barrel and gold at $920 per ounce. The ratio was now at an unsustainable 23 It took 23 barrels of oil to buy one ounce of gold. We didn’t know which price would move, or both, but it was reasonable to assume that the historical balance would be restored. Since March of 2009 this historical relationship has been trading in the range of 13 to 16 Higher than history would tell us, but not extreme enough to make a trade opportunity.

Identifying long term trends, like the probability of inflation, will help change your investment outlook.  Learn to be a big thinker.  Try to see the economy as a giant puzzle that must fit together, and you are the puzzlemaker!

I hope this has helped you with another weapon to put in your quiver of trading tools.

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