What is pairs trading?

Pairs trading involves buying and selling two related stocks when their prices diverge in the expectation they will move back together over time. All manner of investors from large endowments such as Harvard University to retail clients use the strategy because it is regarded as less risky than an outright purchase or sale.  Implementation varies but the idea is the same - to buy the undervalued pair and sell the overvalued pair.

Examples abound however a good starting point is to chart two related stocks that you have an interest in. This will show you how much they have diverged in the past and how quickly they came back together. The ASX website amongst others allows you to chart two stocks or a stock and an index, so the information is readily available.

A recent example of a very successful pairs trade was to buy Coles Myer(CML) and sell Woolworths(WOW). Over the last couple of weeks Coles has, on the back of takeover talks dramatically outperformed Woolworths.  Put it down to good luck or good fortune but an interest in pairs trading often reveals opportunities where otherwise they might go unnoticed.

Trading the pair might consist of buying Coles Myer if you own Woolworths already in expectation that both stocks go up, albeit Coles at a faster rate. Alternatively if you own Woolworths you may consider replacing it with Coles Myer. Or if you trade options, some combination of buying Coles and selling Woolworths – again to capture the relative out performance of Coles v. Woolworths.

So whether you actively trade pairs or not, consider this powerful relationship next time you trade. It may help squeeze several percentage points out of a sale or on entry.

For more examples see www.asx.com.au/pairs

Coles Myer v. Woolworths chart