Pair Trading is the practice of betting on a specific company’s performance by at the same time betting against a rival.   This seems to be odd, but it does have a compelling logic.

A large part of any share’s performance will never be down to the management, no matter how could or bad they are.  The general economy and investor sentiment toward the sector will also have a lot of effect.  This was seen most graphically in the internet boom when an enormous amount of companies with no business plan beyond some neat technology became oversubscribed, overnight.  Recently we’ve seen this to a lesser extent in the commodity boom and the financial services bust which lifted up and dragged down well managed and badly managed companies alike.

Although this “interference” is mainly short term it is still potent, and pair trading has been developed to strip out the influence of this.  Essentially it involves as well as buying a company that the investor likes, also short selling a company in the same sector that the investor dislikes.  As the firms will move in the same direction along with the sector then it more fairly reflects the management’s ability.  It can also be done on an index for the whole sector; selling short an exchange traded fund for that index at the same time as buying shares in what the investor thinks will be the star performer.

In this way if the sector goes up then money is lost on the short but it is gained with the company.  If the sector or the market goes down then the money is lost on the company or gained on the short.  The only thing that matters is the relative performance of the company against its rivals.

Contracts for difference are perfect for this.  They allow an investor to bet against the sector at a fraction of the cost of an actual short sale.  Spread bets can also be useful over a shorter time span.

Last Updated: March 18th, 2010