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Jelly Roll Capital Equity Research |
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Market Analysis, Education, and Wall Street-Quality Stock Reports |
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The Uses of ETFs: Pairs Trading |
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Even the most well-analyzed trade can go awry due to simple bad timing caused by changing macroeconomic events or sentiment. While an investor might find the hidden gem of an industry trading at a sizable discount to its competitors and true worth, such knowledge will be of little help if the rest of the market begins a general sell off. How can investors protect themselves from this risk? Paired trading, where a long position is taken in one instrument and a simultaneous short position is created in a correlated instrument, can help hedge a bet and increase the probability of profit. Although many variations of the paired trading strategy exist, some basic forms are: 1. Being long the best stock and short the worst stock in the same industry 2. Shorting an index and going long a stock that is expected to outperform the index. 3. Buying a broad index and shorting a stock that is a part of the index, but expected to decline. The focus of this article will be on the second strategy, which has become much easier in recent years thanks to the explosive growth of exchange-traded funds (ETFs) that copy various indices. Using ETFs rather than individual stocks in a pairs trade can often make the task of constructing a high probability trade easier because the “long” company one expects to outperform is being set against a larger set of comparative stocks. This lowers the chances that one improbable event will benefit the company that is being shorted. While it might be difficult to ascertain whether Exxon Mobil (XOM) - integrated energy’s highest margin operator - will outperform ConocoPhillips (COP) - which has a lower valuation - it could be much easier to predict that Exxon will perform better than the average integrated oil company due to any number of reasons. Rather than gamble that the market will reward XOM excessively compared to COP, a pairs trade constructed by going long XOM and short XLE would provide similar exposure, while likely increasing the odds of success. Another example would be among semiconductors, a highly competitive and complex industry. Predicting whether Intel (INTC) or Advanced Micro Devices (AMD) will emerge as the winner of the current price war could be an exercise in futility for an investor. If you want exposure to semiconductor stocks in your portfolio, however, you could do this by going long on INTC, AMD, or independent fabricator Taiwan Semiconductor (TSM) and short a semiconductor ETF such as SMH or IGW. Using my preferred company, the trade would be a bet that TSM - the company I consider to be the best of breed among semis - will perform better than its peers, represented by the ETF. While pairs trading still requires plenty of analysis and proper timing, separating companies from the average is often much easier than splitting hairs between two very close competitors. By using ETFs to construct pairs trades, a portion of specific risk can be hedged and the odds of profit can likely be increased. Be sure to check back for more on pairs trading with ETFs; as we will soon have a feature on the 3rd form - being long an index and short a stock.
For more, read The Basics on Exchange-Traded Funds (ETFs) |