1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion

The concept of market-neutral investing is relevant because pairs trading is a type of market-neutral strategy. Joseph G. Nicholas, founder and chairman of HFR Group, wrote in his 2000 book “Market Neutral Investing: Long/Short Hedge Fund Strategies”: “Market-neutral investing refers to a group of investment strategies that seek to neutralize certain market risks by taking offsetting long and short positions in instruments with actual or theoretical relationships. These approaches seek to limit exposure to systemic changes in price caused by shifts in macroeconomic variables or market sentiment.”
 
Market-neutral investing is not a single strategy. Numerous market-neutral strategies include:

  • Convertible arbitrage
  • Equity hedge
  • Equity market neutral
  • Fixed-income arbitrage
  • Merger arbitrage
  • Mortgage-backed securities arbitrage
  • Relative value arbitrage
  • Statistical arbitrage (“StatArb”).

 
The various market-neutral strategies invest in different asset types; for instance, convertible arbitrage takes long positions in convertible securities and short positions in common stock. As another example, merger arbitrage takes long and short positions in the stocks of companies involved in mergers. Market-neutrality can be achieved either at the individual instruments level or at the portfolio level. While the strategies are very different, both in terms of assets and methodology, they all fall under the market-neutral umbrella. This is because each derives returns from the relationship between a long and a short component – either at the individual instruments level or at the portfolio level.
 
How market-neutral relates to pairs trading
Because one position is taken in conjunction with another position to reduce directional exposure, market-neutral strategies often provide a hedge against market risk. In this manner, exposure to the market is exchanged for exposure to the relationship between the long and short positions. This does not imply that market-neutral investing is risk-neutral or even risk-free (it is neither); however, the risks are different than those associated with directional, long-only investing. A market-neutral approach provides an alternative and uncorrelated source of returns when used as part of (but not as a substitute for) an overall investment strategy.
 
Pairs traders limit directional risk by going long on one stock (or other instrument) in a particular sector or industry, and pairing that trade with an equal-dollar-value (or dollar neutral) short position in a correlated stock (for example long $10,000 on stock A and short $10,000 on stock B), typically within the same sector or industry. Because it does not matter which direction the market moves, directional risk is mitigated. Profits depend on the difference in price change between the two instruments, regardless of the market’s direction, and are realized through a gain in the net position.

Pairs Trading: Correlation

Related Articles
  1. ETFs & Mutual Funds

    Getting Positive Results With Market-Neutral Funds

    Find out how these mutual funds can add some flavor to your bland portfolio.
  2. Trading

    Pairs Trading: Introduction

    Pairs trading is a market-neutral trading strategy that matches a long position with a short position in a pair of highly correlated instruments, such as two stocks, exchange-traded funds (ETFs), ...
  3. Trading

    Guide to Pairs Trading

    Pairs traders wait for weakness in the correlation, and then go long on the under-performer while simultaneously going short on the over-performer, closing the positions as the relationship returns ...
  4. ETFs & Mutual Funds

    Hedge Fund Balance Sheet Example

    What once was a niche investment vehicle for the ultra-rich, the hedge fund industry has grown to more than $2.5 billion in assets under management.
  5. Investing

    Pairs Trading: Conclusion

    Pairs trading is a market-neutral investment strategy that seeks profits from the difference in price change between two related instruments. Having well-researched strategies, based on accurate ...
  6. Managing Wealth

    Advantages of Pairs Trading

    Pairs trading is a market-neutral strategy that boasts several advantages: Controlled risk Central to pairs trading is the matching of a long position with a short position in a related, or correlated, ...
  7. ETFs & Mutual Funds

    The Multiple Strategies Of Hedge Funds

    Hedge fund investors or potential investors need to understand how much risk hedge funds take in making money.
  8. Trading

    Arbitrage and Pairs Trading

    At a basic level, arbitrage is the process of simultaneously buying and selling the same (or equivalent) securities on different markets to take advantage of price differences and make a profit. ...
  9. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  10. ETFs & Mutual Funds

    The Secret To Finding Profit In Pairs Trading

    Read about a market-neutral trading strategy using relatively low-risk positions.
Trading Center