An exploration of one particular market-neutral strategy that has not been widely publicized, but has endured for years as a successful approach used by many institutional money managers and hedge fund experts, is the focus of this article. The strategy is called pairs trading. In simple terms, pairs trading consists of buying one stock in an industry and selling short another stock (with which it has been paired via standards to be explained later), usually in the same industry. This approach has become something of a lost, or rare, skill, but, currently, it is resurfacing in the mainstream.

Pairs trading is a non-directional, relative value investment strategy that seeks to identify two companies with similar characteristics whose equity securities are currently trading at a price relationship that is out of their historical trading range. This investment strategy entails buying the undervalued security, while short selling the overvalued security, thereby maintaining market neutrality.

This definition lays out three main areas of focus that play out as subtexts to the overall idea of pairs trading and must be considered and understood before the unified strategy will make sense: Market neutrality, relative value or statistical arbitrage and technical analysis.

1. Market neutrality is the first of the three major features of pairs trading selected for investigation. The term “market-neutral” has come to be a quite appealing label in the last several years and can refer to a wide variety of strategies. Many investors mistake the term to mean “risk free”. This misconception has been narrowly focused on in the marketing of these types of products, and, often, the label is applied to anything that could be considered, even loosely, something that reduces market exposure or systematic risk.
   
   A market-neutral strategy derives its returns from the relationship between the performance of its long positions and its short positions, regardless of whether this relationship is done on the security or portfolio level.

The pairs system is essentially an arbitrage system that allows the trader to capture profits from the divergence of two correlated stocks. Pairs trading contains elements of both relative value and statistical arbitrage in that it often uses a statistical model as the initial screen for creating a relative value trade. A careful pairs trader will perform several layers of analysis on top of the model output before any pairs are actually executed

2. It should be fairly clear by this point that technical analysis plays a very central role in pairs trading. While it is certainly possible to create fundamentally driven pairs trades, the methodology suggested throughout this text uses technicals to perform the majority of the analysis required before trading; fundamentals are used simply as an overlay to ensure that there is no glaringly obvious reason to avoid a trade not captured in the technical indicators examined. Readers who wish to delve more deeply into the subject of technical analysis can consult any one of a number of books written on this subject.

The following graphic example will illustrate the basic concept of pairs trading. The first chart is Xilinx (XLNX); the second is Altera (ALTR). These two stocks are highly correlated and belong to the same industry.

XLNX Weekly

ALTR Weekly

The following chart is XLNX divided by ALTR, Weekly.

That last chart is the ratio of the two stocks. In other words, it represents what would happen if a trader were long XLNX and short ALTR over the last five years. It is important that a pairs trade be done on a dollar-neutral basis (dollars invested in a long stock should be equaled to dollars invested in a short stock; not number of shares).

Notice an almost perfect oscillating pattern of the ratio. It basically means that, when this ratio is at a bottom of the range, a trader would go long XLNX and short ALTR; and when this ratio is at a top of the range, a trader would do the opposite.

Options Application

To reduce risk and maximize profit potential, it is natural to apply options to an attractive strategy such as pairs trading. The first and simplest approach is to substitute stocks with options. Instead of buying one stock and shorting the other, one could buy calls on the long stock and buy puts on the short stock.

Keep in mind that this strategy should be treated as one trade (not two different bets). A trader should open two sides simultaneously and close two sides simultaneously. In the majority of cases, one side will be a winner and one a loser.

The idea of a market neutral strategy is for winners to outperform losers. In this case, a trader essentially strangles a pair of stocks. It is recommended to use in-the-money or at-the-money options to avoid fighting theta decay. If the pair performs as expected (long stock outperforms short stock regardless of the absolute direction), it is a winning trade.

Also, if there is a significant move up or down for both stocks (remember that these are correlated stocks expected to move in the same direction), it is also a winning trade, regardless of which stock outperforms. Just as in a straddle or strangle strategy, if there is a large enough move in one direction, one side can appreciate indefinitely, while the other can only decline to zero. As you can see, by substituting stocks with options, a trader can significantly improve the probability of a successful trade.

Example:

ABC is trading at 50.
XYZ is trading at 75.

A pairs trading strategy would be to buy 3 shares of ABC and simultaneously sell short 2 shares of XYZ in order to be dollar neutral.

Long options pairs trading strategy would be (at-the-money) to buy 3 ABC 50 calls and to buy 2 XYZ 75 puts.

Another interesting approach to applying options to pairs trading is to compare implied volatilities of the two stocks in a pair. If there were a divergence in implied, volatilities of the two analyzed securities, it would present another arbitrage opportunity.

Let's assume that options on ABC are more expensive than XYZ. Instead of buying ABC and selling short XYZ, a trader might consider selling expensive options and buying relatively cheap options while still preserving a pairs trading approach. One would sell ABC puts (neutral / bullish bet on ABC) and buy puts on XYZ (bearish bet on XYZ).

If stocks go up, options expire worthless, and a trader captures the difference in puts. The same outcome holds true if both stocks remain at the same price by expiration. If both stocks go down and ABC outperforms XYZ as expected (XYZ declines more than ABC), there is potentially unlimited gain possibility. This strategy can lose money only if a trader’s pairs trading analysis is wrong and stocks go down.

Many excellent books have been written on options trading describing thousands of intelligent strategies. Almost every strategy can be applied to pairs trading. Remember that the idea in trading is to put probability on our side. A combination of pairs trading and options trading, although it might sound complicated at first, is a great way to increase your probability of success.

These strategies are used by only a handful of hedge fund managers and are not available to the majority of traders and investors. Mastering this approach will open unlimited new possibilities and might change the way you approach the financial markets.