As some of you may already know if you are readers of IntelligentSpeculator, I rarely buy a simple stock. I prefer to do pair trading and almost all of my trades this year have been just that. One long position, one short position. Mike asked me a few questions regarding this method of trading and was kind enough to give me a spot on TFB to explain what I do, how and why.
I will start off today by simply explaining what it is and why I personally like to employ the strategy. Pair trading happens when you select two stocks and decide to invest in one while against the other. One good example would be RIM (Research in Motion) and AAPL (Apple). Both are make mobile phone and both trade on the US markets. After taking the time to look into both companies, I could select the one that I think is most “undervalued”, most attractive and buy that stock.
Up until this point, there is nothing special about the trade. But here comes the different part. Following that, I will go short on the other stock. So for example I would buy Research in Motion (because I believe it is undervalued) and short Apple (because it is too hyped).
Shorting a stock?
When you go long, or buy a stock. You first buy the stock and then at some point sell it back. Going short is simply the opposite. You sell the stock and at some point buy it back. It is seen as a bit more risky because in theory you can lose unlimited money. In theory that is… Because if you a buy a stock for 50$, the worst case scenario is for the stock to go to 0$ at which point you have lost 50$ or 100% of your investment.
If you are short however of a stock at 50$, you can lose 300% of your “investment”. If you sold it at 50$ and buy it back a few months later for 200$, you have lost 150$! In my case, it does not matter much because I have limit losses on all of my trades so I would not let it reach such a loss anyway.
When shorting a stock, there is one more element to consider. You must borrow the stock. Usually, your broker or bank takes care of this and will charge you a fee on the loan. This will however be more or less compensated by the fact that you now earn interest on the proceeds of your short sale.
Ok… Now I understand what it is…but why???
There are two main reasons why I personally use this strategy:
–Not dependant on the market: At any point in time, I am close to having $0 net exposure. So even if the market drops by 20-30%, it does not change much for me. Of course the opposite is true. So there is less dependence on the markets’ performance. In theory, this could create underperformance when markets go much higher but over performance when the market drops.
–Simpifies the game: As mentioned above, these trades help you become “market independent”. It simplifies everything because in this case, your return depends only on two companies, Apple and Research in Motion. It makes it a lot easier in my opinion to trade and get a clear view of what I am doing.
That is all for now. Next week I will go more into the details of how I do my trades, and how I decide to close them, etc.
image source: volpelino
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