A trading strategy made easier with ETFs.
Pairs trading is a trading strategy in which two securities that are very similar in most aspects, but differ in one key aspect, are traded against each other in a long-short fashion. By going long in one security and short the other, you eliminate most risks except for the one you wish to exploit. This article discusses the strategy and how it is made easier with exchange-traded funds.
In the stock market there is never a sure thing. Even when you are confident about an investment idea, some unforeseen event could wipe out your profits. Pairs trading attempts to control for outside risk and allows you to focus on just one risk at a time. For example, let's say that you are a fan of Apple
Pairs trading has been around for a long time, but how can ETFs make them easier? It is difficult enough to come up with one investment idea, but in pairs trading you need to have two ideas. Buying Apple stock was not enough--you also had to know whom Apple was going to beat and what companies face risk profiles similar to Apple's. On top of this, you had to be able to locate shares of RIMM to short. Because of the variety, depth, and ease of shorting ETFs, you can simply short an ETF within the same asset category, index, or industry as the stock you wish to buy.
Here is an example. Let's say that you fear that the Gulf oil-spill crisis will cause much greater liability and reputational risks to BP than is currently perceived by the market. However, if oil prices go up again, BP stock could go up--but perhaps less than other oil companies. Here, we would short BP stock and go long either an oil industry ETF such as Energy Select Sector SPDR
Although correlation is a commonly used statistic to describe the strength of a relationship, a better metric is a stock's beta, which can be used to tell you how many shares you need to short for each long share. For example, let's say you like Coca-Cola
In summary, pairs trading can be a great way to monetize an investment idea without taking unwanted bets. Because of their liquidity, ease of shorting, and wide number of niche and index product availability, ETFs are the perfect other half of the trade.
Michael Rawson is an ETF analyst with Morningstar.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.