Pair trading is taking two stocks, usually in the same sector, and making opposite bets on them: go long one, go short the other. Long/short funds usually take this approach for two reasons. First, it helps hedge them against systemic risk; in other words, by going long and short two names in the same sector, they are hedging themselves against massive losses if the entire sector falls, and they are hedging themselves against a broader decline in equities like what happened in 2008-2009.
The second reason for pair-trading is producing alpha: by going long and short two names in the same sector, you can bet that one company is going to overtake the other company by stealing its market share. In other words, you are betting both on the winner in the market and against the loser in the market at the same time. This aspect of pair trading isn’t as much of a hedge as it is a more aggressive bet on the same thesis—that one company is going to beat out another.
Pair trading is difficult and needs to be done with care, as shorting stocks always carries risk. But pair trading can also augment returns—and it is usually this aspect of pair trading that appeals to institutional investors, since systemic shocks are infrequent and bull markets tend to last longer than bear markets.
A good example of how pair trading augments returns—but should also only be done with the highest level of conviction—comes from two popular fashion names, Michael Kors (KORS) and Coach (COH). This is a classic case of an aggressive upstart against an established name, and since KORS went IPO two and a half years ago, investors in the public market could bet for or against the upstart.
How have the bets paid off so far? A quick look at this chart uncovers the risks and rewards of pairs trading (as well as the need for detailed and comprehensive information):
Click on image to zoom
Obviously, shorting KORS was a big mistake, so the pair trader who thought COH would keep its market share would have been entirely washed out by now. The other side of the trade was much more successful—but notice how going long only on KORS yielded most of the gains, and a simple long bet on KORS would have provided much less risk for not much less return.
Every situation is different, and of course each trade needs to be approached on its own merits, in context, and with a clear exist strategy. However, understanding why and how the pair trade works, and when it is best implemented, is essential to any institutional investor who wants to offer a hedged strategy to help clients outperform the market.