Pairs Trading: Market Neutral Investing
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.
A temporary recovery from a prolonged decline or bear market, ...
The use of an additional indicator or indicators to substantiate ...
Securities analysis that uses subjective judgment based on nonquantifiable ...
A financial statement that summarizes the revenues, costs and ...
The degree to which an asset or security can be quickly bought ...
Profit margin is part of a category of profitability ratios calculated ...
There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
Variable annuities are subject to the ups and downs of the market, so they do not guarantee returns of principal. To mitigate ... Read Full Answer >>
Since 2008, when the Federal Reserve slashed interest rates to zero and then kept them there indefinitely, dividend-paying ... Read Full Answer >>
Hedge funds use several forms of leverage to chase large returns. They purchase securities on margin, meaning they leverage ... Read Full Answer >>
Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>