The unpredictable nature of the stock market makes it difficult to decide whether to invest long or sell short. Traders without a proven strategy who chase the short-term trends may find themselves treading water or even losing money, and falling victim to stock market volatility rather than taking advantage it.  

A strategy called "pairs trading" can help reduce portfolio volatility and make money in volatile markets. A pairs trade is the strategy of matching a long position in one stock with a short position in another. Investors using this technique might go long on a stock they feel will outperform the market or its peers and pair it with a short position in a stock they believe is likely to decline in value.

Tutorial: Introduction To Exchange-Traded Funds

As a hedging strategy, the goal is to have gains from one side of the transaction offset the losses of the other. Although most people use individual stocks in pairs trading, the technique can also work well with exchange-traded funds (ETFs) that cover a particular sector or a broad market index. Here we look at ETF pairs trades and provide historical examples where they would have created a profit for a savvy pairs trader. (To learn more, see ETFs: How Did We Live Without Them? and How To Use ETFs In Your Portfolio.)

Intra-Sector ETF Pairs Trade
ETFs have become increasingly popular over the years, and several ETFs are often available in a given sector. Although ETFs in the same sector may have similar names, they are often very different from one another, both in terms of the stocks they invest in and their investment returns.

One of the most popular investment themes is the emerging markets, particularly interest in China. Two major ETFs that  invest specifically in Chinese stocks include the iShares FTSE/Xinhua China 25 ETF (PSE:FXI) and the PowerShares Golden Dragon Halter China ETF (AMEX:PGJ). As an example of a possible pairs trade here, an investor who believes in China as a solid investment, but at the same time believes the Chinese the market may be faltering, could go long on FXI and short PGJ based on the holdings and strategies of the respective ETFs. (Keep reading about emerging markets in The New World Of Emerging Market Currencies and Broadening The Borders Of Your Portfolio.)

Intra-sector pairs trades such as this one are the least popular type of trade. While ETFs in the same sector might experience dissimilar performance over a given period, the opportunities for success are limited because the difference is likely to be narrower than it would be for pairs trades that use ETFs from different sectors.

Inter-Sector ETF Pairs Trade
Instead of focusing on ETFs that invest in the same sector, this strategy matches different ones to create a true portfolio hedge. To do this, an investor would be long the sector or sectors that have the best outlook and short the sectors that could be vulnerable to a downturn. (Want to know more about pairs trades? Check out Finding Profit in Pairs.)

The strategy makes sense since individual sectors can perform quite differently from each other, and from the market as a whole. For example, during the first 4.5 months of 2008 the S&P 500 Index was down 3% for the year. During that same time period, the best-performing ETFs all focused on the energy sector, with PowerShares DB Energy ETF (AMEX:DBE) up 36%, and the leading performer, the United States Natural Gas ETF (AMEX:UNG), up 51%.

An inter-sector ETF pairs trade would have proved useful in October 2007, when the stock market reached a new high, and the fears of a possible credit crunch in the U.S. began to hit the headlines. The financial sector appeared shaky, because credit issues have a direct impact on banks and other financial institutions. The Fed was on the verge of lowering interest rates several times and the stock market appeared poised for a correction. An investor who was concerned about the market, but who did not want to unload his stocks, could have bought the iShares Utilities ETF (PSE:IDU) because the utilities sector has historically outperformed in rough times. To hedge the long play on IDU, the short side could have been the Vanguard Financials ETF (AMEX:VFH), which represented a sector that appeared vulnerable.

From October through the middle of May 2008, IDU lost 1% and VFH fell 24%. The hedge was not perfect because IDU did not move higher, but shorting the financial sector ETF made the trade very profitable. The net gain of 23% was much better than the 9% loss of the S&P 500 in the same time frame.

Index ETFs Pairs Trade
From year to year, money flows in and out of the varying asset classes. Initially, the trend of the early 2000s involved the small-cap stocks beating the large caps. From 2000 through 2007, the Russell 2000, a small-cap index, gained 52%, while the Dow Jones Industrial Average gained only 14%. Typically, one asset class does not stay on top for more than a few years before falling to the bottom as the investing cycle progresses. Investors who want to play the future flow of money between asset classes can exploit this pattern with index ETF pairs trading.

In 2007, for example, money was coming out of the small-cap stocks and moving into the large-cap asset class for the first time in years. Investors seeking to remain in the market but wishing to hedge a long position could have gone long the Diamonds ETF (AMEX:DIA), which tracks the large-cap Dow Jones Industrial Average, and short the iShares Russell 2000 ETF (PSE:IWM), which tracks small-cap stocks. In 2007, DIA gained 6.5% and IWM lost 2.7%, resulting in a net gain of 9.2% on the position. (Keep reading on this subject in Understanding Cycles - The Key To Market Timing and Sector Rotation: The Essentials.)

Timing An ETF Pairs Trade
Although the timing of any pairs trade is critical, the hedging aspect of the strategy lowers the risk of mis-timing the trade. If an investor does not feel completely certain about a new long ETF position, it may be prudent to hedge it with a sector or index ETF that might lower the risk of the trade without removing all of the reward.

For those with a good understanding of market volatility, pairs trading can be a profitable way to take advantage of it.