Pair Strategy Used By Professionals

I have received plenty of interest on my pair trading lesson and the position I entered in both Apple and Research In Motion. I went long Apple and short Research In Motion.

The approach of matching a long position with a short position in two stocks of the same sector is called pair trading. This creates a hedge against the industry and the general market that the two stocks are trading in. The hedge made is really a bet which you are placing on the two stocks; the stock you are long in in opposition to the stock you are short in.

As its name suggests, a pair trading approach is a double-pronged method, where two outwardly contrasting option or stock trades are entered simultaneously. The strategy can offer somewhat of a safety net to guard against an unforeseen move in a specific sector, while capitalizing on a particular equity’s relative-strength backdrop.

Basically, a pair trader hedges his or her bets, opening positions in 2 interrelated equities or indexes and playing them against one another, choosing 1 call (bullish) position and 1 put (bearish) position. The pair of positions then together provides money-making returns in the middle of a number of outcomes.

For example, I had a good view regarding Apple, but a pessimistic feeling about Research In Motion. I went long on Apple while I shorted Research In Motion.

I also had an uneasy sentiment concerning the whole technology sector. By means of taking a short position in Research In Motion, it allowed me to profit if a large sell off in technology took place. This profit on the short side would compensate my losses in Apple on the long side.

Apple maintained its relative strength versus Research In Motion. The shares rallied and the short side of the trade (Research In Motion) fell. Both sides of the paired trade enter positive territory.

However let’s say the whole tech sector suffers a broad decline. The Research In Motion short is profitable, counter-acting the Apple long position which nets a loss. This is a superior outcome than if I merely went long on Apple.

You’re looking for the percentage change in the market between Apple and Research In Motion to go in Apple’s favor no matter which direction Apple or Research In Motion go.

On May 14, 2009, I went short RIMM at $71 and long AAPL at $122. I exited out of the trade on July 10th 2009 with RIMM at $66 and AAPL at $137. I made 12% on the AAPL long, and 7% on my RIMM short. So the total gain was 19%.

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