Equity Pairs - A Trading Strategy (01/01/09)

Changing market conditions often have a sector-wide impact, affecting the profit and loss (and therefore share price) of numerous companies at the same time.

It is not uncommon, therefore, to see the share price of direct competitors such as Coca Cola and PepsiCo or Yahoo and Google moving in the same direction, giving the impression their share price movements may be related.

Pairs trading is a popular strategy that generates low-risk profits by exploiting the trading pattern between the shares of similar companies without taking a view on the overall direction of the market.

In his most recent report, Anthony Grech explains the logic behind pairs trading and offers a step-by-step guide on how you can identify suitable pairs and construct a basic analysis for successful trading.

Below is a summary of the latest free report from IG Index. You can access the full version in the TradeSense Databank found in the PureDeal platform.

What is pairs trading?

It stands to reason that general economic vagaries that affect the profit and loss (and therefore the share price) of Coca Cola will often impact PepsiCo in a similar way.

Sometimes, however, market conditions may result in a breakdown in the share price co-relation between two companies, thus widening or narrowing the historical price ratio relationship between the two.

This breakdown in price co-relation can be caused by rational, fundamental factors (an economic situation that affects one company but not the other, for example) or by a set of irrational factors such as panic-selling or trader bias.

Pairs traders assume that the latter, owing to its irrational nature, causes only a temporary discrepancy in price movement between co-related shares and the historical price relationship between the two securities will, therefore, be restored with time.

How pairs trading works

Once the historical price ratio changes between two highly co-related companies, assuming that this is a transitory inconsistency, one company can be perceived as being 'undervalued' and the other 'overvalued'.

With pairs trading, you can profit from such situations by exploiting the price divergence between two shares. This can be done by placing a long position on the 'undervalued' share and, simultaneously, placing a short position on the 'overvalued' share, with the intent of taking profits when the price ratio between the two securities converges back to its historical level.

Pairs trading with IG Index

So which equities do you think will pair up well in the coming months? IG Index offers over 7400 shares, plus indices, forex and commodities, allowing you to take a view on pairs trading.

Apply for an account to read the full specialist report from IG Index analyst Anthony Grech, available to all clients, and get set up in minutes.

*Please note: following the FSA's ruling on short-selling banking equities, we currently do not offer short-selling on over 30 UK financial stocks. For detailed information, please see our FAQs.

The above comments do not constitute investment advice and IG Index accepts no responsibility for any use that may be made of them.