pairs trading and market neutral strategies

In short

A friend of mine once told me he had found a sure thing, two bank stocks that always moved together. He bought one and sold the other short, and he slept fine for a few months. Pairs trading is that idea, dressed up with rules. An investor takes two assets that have moved together in the past, buys the one that has lagged, and sells the other short, hoping the gap closes. The aim is to profit from the gap, not from the market going up or down. Costs, borrowing fees, and a gap that keeps growing can all eat the gain, so the work is in the details. Read on, and you will see how the pieces fit and what each one costs.

The whole of it

What it is

I once watched an old farmer pair two mules because they pulled evenly. When one slowed, the other did too, and the wagon stayed straight. A pairs trade rests on the same hope about two securities. You have probably noticed that two companies in the same business, such as two large soft drink makers, often rise and fall together. They face the same customers, the same costs, and the same news.

A pairs trade picks two such assets. The investor buys the one that has slipped behind and sells short the one that has run ahead. Selling short means borrowing shares from a broker, selling them now, and buying them back later to return them. The short seller profits if the price falls, and loses if it rises. The bet is on the gap between the two, called the spread. If the spread narrows back to its old size, the trade pays. It can pay even if both prices fall, as long as the one sold short falls more.

That is why people call it market neutral. A market neutral strategy tries to hold bets that cancel out the push of the overall market. Pairs trading is one kind. A single trade can also use options, which are contracts giving the right, but not the duty, to buy or sell at a set price. Many investors keep it simple and use plain shares.

How it works

A friend of mine who trades says the hardest part is the waiting. The steps themselves are plain enough, and there are four of them. First, the investor looks for two assets with a long history of moving together. Second, the investor measures the usual gap between them. Third, when the gap grows wider than normal, the investor buys the laggard and shorts the leader. Fourth, the investor closes both sides when the gap returns to normal.

The short side brings rules the buyer does not face. A friend of mine who sold short once learned that the broker holds cash or other assets from a short seller as collateral, a kind of security deposit. The broker can ask for more if the trade moves against the seller. This is called a margin call. The short seller also has to pay a borrowing fee to the share lender, and must cover any dividends paid on the borrowed shares while the short is open. Those costs run the whole time the trade is open, so a slow trade is a costly trade.

Margin rules come from both the Federal Reserve and the broker. Regulation T, issued by the Federal Reserve Board, governs how much credit a broker may extend to buy securities. FINRA, the Financial Industry Regulatory Authority, sets its own minimums for margin accounts. Brokers can set stricter terms than either, and many do.

The numbers, and where to find yours

If you are holding a brokerage statement, you can find most of the numbers that matter. The first is the margin requirement. Regulation T sets an initial margin of the current figure, which the official source publishes each year for many stock purchases. FINRA sets a maintenance margin, which is the minimum equity a margin account must keep, of the current figure, which the official source publishes each year. Your broker may ask for more. Look in your account agreement, or call the broker and ask.

The second number is the borrowing fee for the stock you want to short. Brokers post this rate, and it changes from stock to stock and day to day. Hard to borrow shares cost more. Your broker's short locate or borrow rate page is the place to look.

The third is the trading commission and the bid ask spread, which is the small difference between the price a buyer pays and a seller receives. The investor pays it on the way in and again on the way out. On two legs, that is four crossings of the spread.

Taxes matter too. Gains on positions held for a year or less are taxed as short term gains, at ordinary income rates. The Internal Revenue Service explains capital gains and losses in Publication 550, Investment Income and Expenses. Short sales are covered in that publication as well. The publication explains how a short sale is treated, so read its short sale section for the exact holding period rules. A strategy that closes trades within weeks will often meet the short term rate. A tax professional can say how the rules apply to a particular trade.

A worked example

A neighbor of mine named Marcus decided to try a small pairs trade on paper first. He watched two soft drink makers, call them Company A and Company B. Both traded near $50 for a long while. One day A rose to $54 and B stayed at $50.

Marcus believed the gap of $4 was too wide. He bought 100 shares of B and shorted 100 shares of A. The long side cost 100 shares at $50, which is $5,000. The short side brought in 100 shares at $54, which is $5,400.

Three weeks later the gap closed. A fell to $52 and B rose to $52. Marcus sold B for 100 shares at $52, which is $5,200. He bought back A for 100 shares at $52, which is $5,200. The long side gained $5,200 minus $5,000, which is $200. The short side gained $5,400 minus $5,200, which is $200. Together that is $400.

Now the costs. Suppose the borrowing fee was 2 percent a year on $5,400. Over 21 days, that is $5,400 times 0.02 times 21 divided by 365, which is about $6.21. Suppose A paid a dividend of $0.30 a share during the trade. On 100 shares, Marcus owed $30 to the lender. Add commissions of $4 on each of four trades, which is $16. His costs total $6.21 plus $30 plus $16, or $52.21. His gain after costs was $400 minus $52.21, which is $347.79.

Not bad. But notice what carried it. The gap had to close, and it had to close fast. Had A stayed at $54 and B at $50, Marcus would have earned nothing and paid fees every day.

Where it goes wrong

Every trader I have met has a story about a gap that kept growing. Two stocks can move together for years and then part ways for good. A company may lose a lawsuit, change its business, or get bought. Then the old pattern is gone, and the trader holds a bet on a relationship that no longer exists. The short side has no ceiling on its loss, because a price can rise without limit.

Timing is another trouble. A trade can be right in the end and still ruin the trader first. If the gap widens before it narrows, the margin call may come early. The broker can then close the position at a bad moment. The trader was right. The trade was still lost.

Costs are a quiet thief. Borrowing fees, dividends owed, commissions, and the bid ask spread all add up. Small trades with small gaps can vanish into them, as Marcus's $400 shrank to $347.79. Shares that are hard to borrow can also be recalled by the lender, which forces the short to close at once.

Last, a friend of mine once took market neutral to mean free of loss. Those are two different things. The phrase describes one narrow thing, a lowered link to the overall market. The trader still faces loss, and the loss can be large.

Questions to answer before you leave this page

If you were to try this, could you afford to lose the whole amount you set aside, and would you still sleep well? Do you know what your broker charges to borrow the shares you would short, and have you checked it today? Have you read your margin agreement, and do you know the point at which the broker may close your position without asking? Can you say, in plain words, why the two assets you picked have moved together, and what would break that link? Have you added up the commissions, the bid ask spread, the borrowing fee, and any dividends owed, so you know how big the gap must be before you earn a cent? And have you looked at IRS Publication 550 to see how short sales and short term gains would be taxed on your own return?