July 04, 2008 at 1:00 pm by Tom Lydon
In an attempt to stave off market volatility, trading in pairs of exchange traded funds (ETFs), or pairs trading, can be an option for investors who want to hedge market downturns.
Pairs trading is a strategy that reduces portfolio volatility, while allowing you to make money in a turbulent market. A pairs trade, as defined by Matthew McCall for Investopedia, is the strategy of matching a long position in one stock with a short position in another. Investors usually go long in one stock they feel will outperform and pair it with a short position in a stock they believe will drop in value.
The hedging aspect of this is to have gains from one side of the transaction offset the losses of another. This strategy can be done with ETFs that cover a sector, or the broad market.
An example:
- If you went long on iShares FTSE/Xinhua China 25 Index (FXI) down 7.2%, and short the PowerShares Golden Dragon Halter (PGJ), down 12.2%, based on their holdings. This would have given a net return of +5%.
The idea of a pairs trade is basically to lower the risk of the trade without removing all of the reward.
If you’ve got the understanding of market volatility and are aware of the risks, pairs trading can be an option for investors who want to give it a shot. But it might not be for everyone.
