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Pair Trades

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Curriculum Content

Pair Trades involve both long and short strategies, both executed together. Pair trades are relative to each other, long on a firm with an optimistic outlook, short on another firm with a pessimistic outlook. Exposure levels do play into the trade. If you think that the short trade’s price will depreciate more than the price appreciation on the long side, more money should be placed into the short side trade. If you think the long trade will price appreciate more than the short side’s depreciation, you should place more money into the long side. The bias here is towards the two specific firms involved in the trade. The bias is not explicitly supposed to be based on the market, but it can be if you anticipate major market movements upwards or downwards.

Each trade must be logical on its own and interwoven into the other for it to qualify as a pairs trade. You should justify your trade on the movements of fundamentals, ratios, and events. This is especially true for the short side, since shorts have theoretically endless risk and can easily turn against you if an acquisition or merger is proposed.

The relativity of the two trades should be direct and explicit. Pair trades typically occur between two firms within the same industry. If “Great cell Corporation” is encroaching on the market share of “Bad-phone Incorporated” with stronger substitute products while maintaining stronger financial fundamentals, the pair trade would be long on “Great cell Corporation” and short on “Bad-phone Incorporated”. This would be especially true if Bad-phone’s fundamentals were rapidly deteriorating.

Pair Trades can also occur across industries. If the development of a new technology is phasing out an older technology, it can be sensible to long the new technology leaders. At the same time, the firms who are strategically centered on providing the old technology would be the short side trade. As smartphones became popular, personal digital assistants (also known as Palms or PDAs) fell out of popularity. The features in smart phones incorporated all of the features of PDAs, and consumers no longer had to purchase cell phones and PDAs separately. Firms which exclusively made PDA devices and did not convert into smartphone markets were annihilated in the marketplace. Logical pair trades short sold PDA device manufacturers and purchased smart phone manufacturers.

The same occurred for developers of typewriters as personal computers and word processors appeared. The new features of saving, loading, and copying removed any need for manual typewriters. Any manufacturer that focused almost purely on typewriters found their market shares eroded over the course of decades, not by a competitor but by an entire new industry replacing them. The pair trade for this situation would have traded long on Word Processing developers and short on typewriter manufacturers. Both of these examples indicate you can learn to identify trends that will erase current services and products in favor of more convenience. You should short sale shares most likely to suffer from the trend and long buy shares most likely to benefit from trends. Identify both by their fundamentals, ratios, and events surrounding the two firms.

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