When a FTSE 100 stock such as Barclays can drop by more than 50% one week then more than double the next, it’s nigh on impossible to know which way the market will move. But there is a way to profit regardless – it’s called ‘pairs trading’. Volatility can disrupt the normal relationship – or ‘correlation’ – between prices for pairs of assets, say two share prices. Pairs traders bet that those relationships will be restored pretty quickly. So rather than worrying about whether a market, sector or share is about to head up or down, the strategy looks for two prices that are out of kilter with each other and bets on a correction.
The mechanics of pairs trading
Shorting – betting on falling prices – is a key tool for the pairs trader. Since shorting stocks is tricky for retail investors, better options are spread bets or ‘contracts for difference’. Of the two, spread bets are simpler – the only trading cost is the bid-to-offer spread – and all profits are free from capital-gains tax.
So, as an example, you might decide that Tesco, trading at £3.75, is expensive relative to Sainsbury’s, trading at say £3.00. Maybe you have a hunch that Tesco’s recent expansion into Asia will prove unwise or you have been watching the share price ratio closely (see below). You place a pair of trades – a £3,000 ‘long’ up-bet on Sainsbury’s at £10 per point (1 point = 1 pence) and a £3,000 down-bet on Tesco. This time it’s at £8 per point (take the £3,000 you want to bet and divide by the share price of £3.75, or 375 ‘points’ to give £8). Note that this ignores the bid-to-offer spread – for example, you might buy Sainsbury’s at your broker’s offer price of say £3.05, so in practice the up-bet is placed at £9.84 per point (£3,000/£3.05) rather than £10.
Assume a week later the Sainsbury’s share price has dropped to £2.90 but the Tesco share price has also dropped to £3.40. You decide to ‘close out’ the pair by selling Sainsbury’s at £2.90 and buying Tesco at £3.40. The result is a 10 point loss on the Sainsbury’s up-bet, or £100. However, that is offset by a gain on the Tesco down-bet of 35 points, or £280 (£8 x 35 points). Overall, in spite of the fact that both shares have fallen, the gap between their share prices narrowed as you hoped from 75p to just 50p. So you walk away with a tax-free gain of £180.
Pairs trading: deciding which way to bet
So how do you know when two prices are aligned, or out of whack? Strategist Anthony Grich at IG Index suggests some factors that indicate a suitable ‘pair’. A good start is two companies in the same sector. A glance at the last 12 month’s share price graphs should reveal whether there is any price relationship. The strength of the relationship can then be tested with a correlation coefficient. For Tesco and Sainsbury’s, for example, it’s 0.91, so, given the highest possible score is 1.0, this says the two shares usually move up and down in tandem. Then, by comparing the two share prices over say a year, you can gauge the average (or ‘mean’) price relationship. Between 31 October 2007 and 31 October 2008, for example, the Sainsbury’s share price was typically 88% of the Tesco share price. What’s more, it sat between 82% and 94% of Tesco for most of that period.
So if the Sainsbury’s share price suddenly leaps to say 110% of Tesco, a pairs trader would sell Sainsbury’s and buy Tesco. Equally, if it dropped to just 70%, then buying Sainsbury’s and selling Tesco should make money as you expect the gap to revert to nearer 88%.
Pairs trading: what could possibly go wrong?
Quite a lot – so be careful.
First, relationships change. Tesco’s aggressive overseas expansion might render comparisons with Sainsbury’s less apt, for example.
Next, you suffer two sets of bid-to-offer spreads. These need to be deducted from your expected profits.
Third, because you are not betting on whether the market rises or falls, stop-losses could kill your profits on one or both legs – so traders don’t tend to use them. But that spells potentially big losses if you bet a large sum on the gap between two share prices narrowing and it then widens sharply.
Finally, you often need to be quick, as a price anomaly may not last long.
Three pairs-trading ideas
As Grich comments, some investors are puzzled by the fact that Brent crude oil is trading several dollars a barrel above West Texan Intermediate. So a short Brent, long WTI trade could make money. Sterling’s recent collapse could support a short German DAX and long FTSE position given the higher number of exporters in the UK index. As this was written, the Sainbury’s/Tesco price ratio was at 95%, just outside its upper range – perhaps a good time to place a ‘long Tesco, short Sainsbury’s’ pairs trade.