What is a Pairs Trade?

A pairs trade is an investment strategy that involves matching or pairing a long position on one security with a short position on another security. This effectively creates a hedging transaction that allows the investor to profit in some manner in just about any type of market environment. In order for a pairs trade to work efficiently, the two securities used in the hedge strategy must be associated with the same market sector. Should one position falter, the other is likely to prosper, allowing the investor to achieve a return between the activity of the two positions.

One of the main benefits of a pairs trade is that the pairing of opposing positions on two stocks in the same market sector positions the investor to profit from just about any type of situation that occurs in the marketplace. This includes situations in which the market remains fairly flat, or experiences an upturn or a downturn. As long as the market moves in one direction or the other, one position will experience a loss while the opposing position realizes a gain. Even if the market is flat, the investor does not stand to lose anything, making it possible to hold the position without creating any type of financial distress.

The key to a successful pairs trade is choosing the right securities for the combination of a long position and a short position. One of the simplest ways to choose the right stock options is to focus attention on two companies that are in direct competition with one another. For example, an investor may decide to create a pairs trade that involves a short position with one well-known soft drink company while also creating a long position with another soft drink company that is considered to be a chief rival. The same approach could be used to structure a dual investment strategy involving two competing electronics firms, two retailers that target the same consumer base, or even two cosmetic companies that compete for the business of a specific consumer demographic.

Choosing the right securities to utilize in a pairs trade takes much of the focus off the market where the two stocks are traded, and highlights the performance of the stocks themselves. Since any movement in the market will result in an increase in one position and a loss in the other, the investor is protected from incurring an overall loss in most cases. While a pairs trade does virtually eliminate risk, it is important to remember there is always the slight risk that shifts in the economy or events outside the control of the marketplace could result in losses on both the short and the long position. While the chances of such a phenomenon occurring are extremely low, it is important for investors to consider this possibility when choosing the two securities for the pairs trade, and base the selection on what type of factors could adversely affect the performance of both securities.