The unpredictable nature of the stock market makes it difficult to decide whether to invest long or sell short. Traders who chase the short-term trends, without a proven strategy, 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.

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.


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 in China. Two major ETFs that invest specifically in Chinese stocks include the iShares FTSE/Xinhua China 25 ETF and the PowerShares Golden Dragon Halter China ETF. 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 market may be faltering, could go long on iShares FTSE/Xinhua China 25 ETF and short on PowerShares Golden Dragon Halter China based on the holdings and strategies of the respective ETFs.

Intra-sector pairs trades such as this one are the least popular type of trade. While ETFs in the same sector might experience dissimilar performances 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.

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%. During that same time period, the best-performing ETFs all focused on the energy sector, with PowerShares DB Energy ETF up 36%, and the leading performer, the United States Natural Gas ETF, 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 or her stocks, could have purchased the iShares Utilities ETF, because the utilities sector has historically outperformed in rough times. To hedge the long play on iShares Utilities, the short side could have been the Vanguard Financials ETF, which represented a sector that appeared vulnerable.

From October through the middle of May 2008, iShares Utilities ETF lost 1% and Vanguard Financials ETF fell 24%. The hedge was not perfect because iShares Utilities 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, which tracks the large-cap Dow Jones Industrial Average, and short the iShares Russell 2000 ETF, which tracks small-cap stocks. In 2007, Diamonds gained 6.5% and iShares Russell 2000 lost 2.7%, resulting in a net gain of 9.2% on the position.

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.

The Bottom Line
Pairs trading with ETFs can help investors reduce portfolio volatility and make money in uncertain markets. As with all trading, however, investors should do their research and consult the experts before making trades.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares Asia 50

    Read more about BlackRock's iShares Asia 50 Fund, an ETF that follows the four "Asian Tiger'' nations plus China.
  2. Mutual Funds & ETFs

    ETF Analysis: WisdomTree International LargeCp Div

    Learn more about the WisdomTree International LargeCap Dividend fund, an income-based international equities ETF that focuses heavily on the United Kingdom.
  3. Chart Advisor

    ChartAdvisor for September 4 2015

    Weekly technical summary of the major U.S. indexes.
  4. Mutual Funds & ETFs

    ETF Analysis: United States Gasoline Fund

    Learn about the United States Gasoline Fund, the characteristics of the exchange-traded fund, and the suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: United States 12 Month Oil

    Find out more information about the United States 12 Month Oil ETF, and explore detailed analysis of the characteristics, suitability and recommendations of it.
  6. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Nasdaq Biotechnology

    Find out information about the ProShares Ultra Nasdaq Biotechnology exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  7. Mutual Funds & ETFs

    ETF Analysis: Direxion Daily S&P Biotech Bull 3X

    Learn more about the Direxion Daily S&P Biotech Bull 3x exchange-traded fund, a new triple-leveraged ETF tracking biotechnology equities.
  8. Mutual Funds & ETFs

    ETF Analysis: First Trust Health Care AlphaDEX

    Learn more about the First Trust Health Care AlphaDEX exchange-traded fund, an indexed fund that uses an advanced stock selection methodology.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI Emerging Mkts

    Learn more about the PowerShares FTSE RAFI Emerging Markets ETF, a fundamentally weighted fund that tracks emerging market equities.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares Cali AMT-Free Muni Bond

    Learn more about the iShares California AMT-Free Municipal Bond exchange-traded fund, a popular tax-advantaged ETF that dominates its category.
RELATED TERMS
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  3. Indicator

    Indicators are statistics used to measure current conditions ...
  4. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  5. Lion economies

    A nickname given to Africa's growing economies.
  6. Mass Index

    A form of technical analysis that looks at the range between ...
RELATED FAQS
  1. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  2. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  3. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!