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 category of ratios measuring profitability calculated as net ...
A three-month period on a financial calendar that acts as a basis ...
A financial ratio that measures the extent of a company’s or ...
The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
The difference between the present values of cash inflows and ...
Long-term debt consists of loans and financial obligations lasting ...
Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
One of the best assets a person can have is an individual retirement account (IRA), and children can have one as long as ... Read Full Answer >>