Market Neutral..
Wanted to jot this down before I forget: the most important reason why I am exploring pairs, is the fact that pair trading strategies are “market neutral”. A good article by Douglas Ehrman explains this with an example:
Many traders think of a pair as a “spread” trade, but this comparison is not quite accurate. A spread trade creates either net long or net short exposure, but a properly executed pairs trade is dollar-neutral. By maintaining a market-neutral position, the effects of market direction can be largely eliminated from the trade.
Consider the following comparison of a spread trade vs. a pairs trade:
Stock A: $20 per share
Stock B: $10 per share
Spread trade
Long 100 shares of stock A: $2,000
Short 100 shares of stock B: $1,000
Net long: $10 per share ($1,000)
This is a hedged, bullish position.
Pairs trade
Long 100 shares of Stock A: $2,000
Short 200 shares of Stock B: $2,000
Net long/short: $0
This is a true market-neutral position.
Scenario 1
Both stocks rise 50 percent.
Stock A: $30
Stock B: $15
Scenario 2
Both stocks fall 50 percent.
Stock A: $10
Stock B: $5
A spread trade is a market bet with a built-in hedge, while a pairs trade is a market-neutral position. In the first scenario’s bull market, the spread trade gains $500 (Stock A’s $1,000 profit - Stock B’s $500 loss), and the pairs trade is flat (Stock A’s $1,000 profit - Stock B’s $1,000 loss).
In the second scenario’s bear market, however, the spread trade loses $500 (Stock A’s $1,000 loss - Stock B’s $500 profit) as the pairs trade stays flat. Here, the spread trade loses money despite both stocks dropping by an equal percentage. In both scenarios, the specifics of either stock had no effect on price — the entire move is explained by the broader market fluctuations.
The trade must be market-neutral to ensure it won’t lose money unless there’s a change in relative performance (i.e., one stock performs better than the other).
Similarly, if both stocks dropped by $5, the spread trade would remain flat even though Stock A outperformed Stock B (Stock A loses 25 percent, while Stock B loses 50 percent). A trade can only capture this relative performance if the trade is dollar-neutral.
And thats the whole concept: The trade MUST be market-neutral to ensure it won’t lose money unless there’s a change in relative performance (i.e., one stock performs better than the other).
1 year ago