Pairs Trading: What Is That?
Quite a few firms are getting involved with "pairs trading" and we thought we just might take a moment to explain what the term means. Pairs trading means that you simultaneously go long one stock in a sector and you go short another one. On the surface, you might be thinking, "why would anyone do that?" Well, for a couple reasons. First, in just about every sector there are a couple leaders and everyone else is a laggard. For instance, in the tech area, IBM consistently outperforms others in general. In the financial sector, GS can rack up points better than most. So, leaning long the leaders when the time is right often pays you generously. Likewise, some companies often produce more good news than others. Some of it is "manufactured" and some of it is real, but the street tends to pay attention to the news generators and they often press them higher. So, if you go long a stock putting out good news, while simultaneously shorting their competition, you will often see something like this happen: The stock putting out the good news pulls the sector higher. But, in a day or two, the others in the sector often start falling back, while the news generator holds up, or even keeps rising. If you are long the news stock, and short the weakest competitor in the sector, chances are good that both will be winning plays. This isn't a new concept, but one that lost favor in the 90's, as everyone simply went long. Now the idea of pairs trading is catching on again, and it's worth your doing some homework on it if it sounds intriguing to you.
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