Pairs trading: profit whichever way the market goes

Market-neutral, or pairs trading, sounds daunting. But it really isn't. All you do is buy a stock, index, currency or commodity that you think is undervalued, and then sell short a related asset you believe is overvalued.

The trick is to pick two assets that are highly correlated. That is, assets that tend to bounce around in a similar range and respond to the same catalysts. That way the relationship won't get too heavily skewed one way or the other.

This is important by picking bedfellows you reduce your market risk. That is, the systemic risk that you can't otherwise diversify away.

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Take the example of the textbook aggressive and defensive UK investors: a high-risk investor holds miners, oil explorers and tech stocks; a low-risk investor holds telecoms, tobacco and drug stocks.

When a correction hits the market both investors are affected. While the high-risk investor will be hit much harder than his low-risk counterpart, it's unlikely that the defensive investor escaped the downdraft completely unscathed. That's because no matter how low your risk appetite, or how well you've diversified, market risk always catches up with conventional 'long-only' investors.

But that's not a problem for market-neutral pairs traders. Because they are both long and short a particular market, they cancel out market noise in other words, it doesn't matter if the market itself is rising or falling. They profit (or lose) solely based on the discrepancies between two prices.

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To see how this can work, look at a recent pairs-trading tip I put together. I was hunting for opportunities across Europe's most interesting stock markets, including the Swiss index (the SMI). But then I posed the question, "But what if everything falls?" Which is pretty apt, given the FTSE's 8.5% sell-off since the article was published.

My solution was to "buy the SMI and short the FTSE 100". Why? Because the FTSE houses volatile stocks such as Rio Tinto, Randgold Resources and Tullow Oil. These are exactly the types of stocks that have fallen the furthest. And this drags on FTSE performance. By contrast, the Swiss index is highly defensive.

So how has it worked out? Well, since we first published the pairs trading idea, the Swiss index has fallen 6.2% and the FTSE 8.5%. So the trade is in profit. How? Because the money you would have lost by being long the SMI, is more than made up for by the money you would have gained by being short the FTSE.

If you were long SMI and short FTSE, you'd be up 2.3%. And if you'd put the trade on via spread betting, you'd have registered a 292 point return (assuming that you'd "normalised" the trade by ensuring that a one-point fall in the FTSE had the same impact as a one-point rise in the SMI read more on the mechanics of pairs trading). Not bad given the FTSE's 533 point decline.

In this gloomy climate, it's difficult to predict what will come next. But if you still harbour doubts about European monetary union, or over the spike in volatility in the US, this might still be a suitable trade for you to hang on to.