The investment approach known as “pairs trading” is one of the easiest ways for a retail investor to stay hedged. Here’s how it works…
First, as its name suggests, pairs trading involves a “pair” of investments. You’ll typically choose two investments that have a logical relationship to one another. That means you’ll be looking at gold/silver, oil/natural gas or Germany/Spain. There’s no sense in pairing up two investments that have little to do with one another, like the Japanese yen and corn.
The second step in the process involves taking a ratio of the two investments. This is simply:
Ratio = Price of Investment A ÷ Price of Investment B
Here’s what a ratio chart of two stock indices (Dow Jones and Nasdaq) looks like:
In this example, the Dow Jones Industrial Average (DIA) is “Investment A” and Nasdaq (QQQ) is “Investment B.”
As you can see, the ratio peaked in early 2009 (when all major stock indices bottomed) and has been trending lower ever since.
So what does this tell us?
The ratio has been declining, meaning the Nasdaq (the bottom number) has been outperforming the Dow (the top number). Specifically, the Dow was three times the price of the Nasdaq in 2009. Today, the Dow is less than twice the price of the Nasdaq.
Now that we understand the current trend, we have a decision to make. Do we think the trend will continue? Or reverse course?
I tend to think the ratio will reverse. This will certainly occur when investors become fearful because that’s when they’re likely to buy “safer” Dow Jones stocks instead of “risker” Nasdaq stocks.
If you think the ratio is too low and expect it to move higher, here’s what you do:
1) Buy Investment A (DIA), and
2) Sell Investment B (QQQ).
If you expect the ratio to head lower, you’d do the opposite.
Why is this a “hedge?”
Well, DIA and QQQ are highly correlated. On days when the market is up – both DIA and QQQ are typically higher. Likewise, DIA and QQQ move lower together on down days.
By buying one investment and selling the other, your account balance will change (positively and negatively) with less volatility than if you had simply bought or sold just one – taking an outright bullish or bearish position.
That’s why pairs trading is a great tool for investors who want to be involved in the markets but don’t want sleepless nights as their portfolios swing wildly with all the volatility.
If you haven’t done so already read the Survive & Prosper issue on “Why the Stock Market is Like Vegas”