Great Pair Strategy I Used In May 2009
I have received plenty of attention on my pair trading article and the play 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 forms a hedge against the industry and the general market that the two stocks are trading in. The hedge created is basically a wager that you are placing on the two stocks; the stock you are long in versus the stock you are short in.
As its name implies, a pair trading tactic is a dual-pronged strategy, where 2 apparently unrelated option or stock trades are opened at once. The strategy can give somewhat of a safety net to defend against an unforeseen move in a particular sector, while capitalizing on a particular equity’s relative-strength backdrop.
Basically, a pair trader hedges his or her bets, opening positions in two 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 collectively provides profitable returns in the midst of a number of outcomes.
For instance, I had a great point of view regarding Apple, but a pessimistic feeling concerning Research In Motion. I went long on Apple at the same time as I shorted Research In Motion.
I also had an uneasy sentiment about the whole tech sector. Through taking a short position in Research In Motion, it permitted me to profit if a large sell off in tech took place. This profit on the short side would counteract 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 us 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 are looking for the percentage change in the market between Apple and Research In Motion to move in Apple’s favor no matter what direction Apple or Research In Motion go.
On May 14, 2009, I went long Apple at 122, and short Research In Motion at 71. I exited out of the trade on July 10th 2009 with RIMM at $66 and AAPL at $137. I made 12% on the Apple long, and 7% on my Research In Motion short. Hence the total gain was 19%.
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