Pairs Trading
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INVESTOR PROFILE |
|
|---|---|
| Outlook | Positive or Negative |
| Risk Profile | Medium |
| Time Frame | Short - Medium |
Pairs trading involves speculating on the relative performance of two different securities.
Generally the investor takes a long position in one share and a short position in a different share. Typically, both of these shares will be within the same industry sector.
In a highly developed market like Australia, industry rationalisation has led to many sectors of the economy being dominated by only a handful of major businesses. In banking there are the “Four Pillars” (Westpac, CBA, ANZ and NAB); in telecommunications Optus and Telstra have dominant market shares; and in mining BHP and RIO tower over the competition. In these industries share price movements are often affected by economic factors external to the companies themselves.
For example, since the start of the recent mining boom both BHP and RIO have benefited from an increasing demand for metals. This has led to a high degree of correlation between the two company’s share prices, illustrated in the following graph:
The chart above is included only to illustrate the correlation between two stocks over a period of time. Past performance is not a reliable indicator of future performance.
When executed correctly, investors can use pairs trading to take advantage of mispricing between two share prices. Typically an investor will find two companies within the same industry whose share price movements are historically highly correlated. They will go long the share they believe is undervalued and short the share that they believe to be overvalued. The two positions should be equal in dollar value.
If the investor is correct they will profit on either the long side or the short side of the trade (and occasionally on both sides at once). If economic factors external to the companies had a negative impact on the industry as a whole then the short position would act as a natural hedge to the long position neutralising to a certain extent any adverse price movements in both stocks.
Case Study
You should note that this example is illustrative only. It is not a recommendation to make any investment in any share, and should not be taken as personal advice. With a MQ Prime Facility, you are responsible for selecting the share for any position you take out. As such, the performance of any share position will depend mainly on your own investment decisions.
Cathy has been following the supermarket retailing industry for a number of years and has started to notice that the price of Woolworths is relatively undervalued when compared to its closest rival Coles. Cathy knows that Woolworths are due to report their quarterly sales figures in 3 days time and believes that they will surprise the market on the upside. She thinks that this event may be a catalyst for people to ‘switch’ from Coles into Woolworths. Cathy decides to use the MQ Prime Facility to construct a pairs trade to reflect her view that the price of Woolworths is going to increase relative to the price of Coles.
She uses the Prime Facility to buy 1000 Woolworths shares at $25.00 and sell an equivalent value of Coles which is 2000 Coles shares at $12.50
On December 10, Woolworths announces a rise in quarterly sales of 10%. The price of Woolworths rallies to $25.60 on the back of this news and the price of Coles shares remains unchanged at $12.50.
The following table shows the result of Cathy’s pairs trading strategy:
| Woolworths | |
|---|---|
| Buy Value |
$25,000 |
| Sell Value |
$25,600 |
| Profit |
$600 |
| Coles |
|
| Sell Value |
$25,000 |
| Buy Value |
$25,000 |
| Profit |
nil |
| Total Profit |
$600 |
This analysis does not include the effect of interest, fees or taxes.
If instead the price of Woolworths had fallen relative to the price of Coles, Cathy would have suffered a net loss on her pairs trade.
Due to recent rebranding of our products, we now use the term "MQ" in place of "Macquarie" in all marketing and informational material concerning our CFD, Prime and Cash Account products (except where we refer to a Macquarie company). For example, we now use "MQ CFDs" rather than "Macquarie CFDs". Please note that this rebranding has not affected the substance of the products in any way and they remain issued by Macquarie Bank Limited.
MQ Prime can be high risk and is intended for experienced investors. Consider carefully whether a MQ Prime Facility, MQ Prime Cash Account and/or a MQ CFD account, each issued by Macquarie Bank Limited ABN 46 008 583 542 are appropriate for you; talk to a financial adviser; and before investing read the relevant product disclosure statement available from www.macquarie.com.au/prime. Information is current at 5 February 2008 and may change without notice.
