Pairs Trading 101

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Pairs Trading 101

Pairs trading is a strategy where you buy one security and you sell (short) another. This means you profit off the difference between the two instruments while being free of market risk. Here is an example, you bought Mastercard and sold (short) Visa. If the S&P500 drops 10%, Mastercard is down 11%, and Visa is down 12%, you made 1%. In this case the profit from the short covered the losses from stock you bought.

While the potential profit from this trade is smaller than if you were to just buy a stock, the potential losses are also much smaller. This trade is meant to minimize risk, and in times like this that is a good thing. Investors can utilize this strategy to buy strong, well known, and quality companies in an industry and selling (shorting) companies that are not well known and lack quality in the same industry. Before executing this trade it is important to look at historical graph of both securities to ensure that they tend to move very closely.

Pairs trading can be used as an alternative to cash in invstr as the trade will last for a month or less and the 10% position will not lead to much risk. Since there is no return on cash, a pair trade can give a low, but extremely safe return (barring something extraordinary), as long as the two stocks tend to move together. This small return will increase your monthly return while keeping the risk of big market swings to a minimum.

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