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Pairs trading: hedging out the industry risk


A stock trader believes that the stock price of FOO, Inc., will rise over the next month, due to this company's new and efficient method of producing widgets. He wants to buy FOO shares to profit from their expected price increase. But FOO is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the FOO shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of FOO's direct competitor, BAR.

In a highly developed market like Australia, industry rationalisation has led to many sectors of the economy being dominated by only a handful of major businesses. In banking there are the “Four Pillars” (Westpac, CBA, ANZ and NAB); in telecommunications Optus and Telstra have dominant market shares; and in mining BHP and RIO tower over the competition. In these industries share price movements are often affected by economic factors external to the companies themselves.

If economic factors external to the companies had a negative impact on the industry as a whole then the short position would act as a natural hedge to the long position neutralising to a certain extent any adverse price movements in both stocks.

Case Study
The first day the trader's portfolio is:


  • Long 1000 shares of FOO at $1 each
  • Short 500 shares of BAR at $2 each
(Notice that the trader has sold short the same value of shares.)


On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. FOO, however, because it is a stronger company, goes up by 10%, while BAR goes up by just 5%:


  • Long 1000 shares of FOO at $1.10 each — $100 profit
  • Short 500 shares of BAR at $2.10 each — $50 loss
(In a short position, the investor loses money when the price goes up.)


The trader might regret the hedge on day two, since it reduced the profits on the FOO position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash -- 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since FOO is the better company, it suffers less than BAR:


Value of long position (FOO):

  • Day 1 — $1000
  • Day 2 — $1100
  • Day 3 — $550 => $450 loss
Value of short position (BAR):

  • Day 1 — $1000
  • Day 2 — $1050
  • Day 3 — $525
Without the hedge, the trader would have lost $450. But the hedge - the short sale of BAR - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.


There were many articles about who is best&worst prepared for a downturn between housebuilders: mdc vs dhom; subprime lenders- CFC vs AHM; investment banks etc. I feel really sad that I didn't know about this hedging strategy before. 

PS:statements were from these two websites:
http://en.wikipedia.org/wiki/Hedge_(finance)
http://www.macquarie.com.au/emg/prime/strategies_using_prime/pairs_trading.htm 
By GordonGekko at 2007-11-24 18:59 | Stocks | GordonGekko's blog


Pairs Trading

Pelcmarek,

Pairs trading is at least as risky as a single long position. It's just a bet on a separate assumption. The example given above doesn't remove industry risk. If the entire sector were shorted rather than merely one competitor, you could claim industry risk was removed. In the given example, you are actually doubling your company (or business) risk. You have the risk that your long position (FOO) has something bad happen to that company AND the risk that something extraordinarily good happens to your short position (BAR).

If you have a net neural exposure to the market (50% long and 50% short), you have eliminated market risk, but not company or industry risk. You have merely substituted one type of risk for another. I know that many quant funds specialize in pairs trading, but they tend to take relatively large positions for short periods of time and they use data that the average investor doesn't have access to. Unless you are trading full time, this strategy is a tough one for the little guy. I did find it quite funny that the two positions FOO and BAR together sound like FUBARLaughing

If you are interested in risk management, Satyajit Das has some very interesting things to say. Here is an exerpt from his book.

SunTzu


By Suntzu at Sun, 2007-11-25 20:42 | login or register to post comments

SunTzu


You are right in example above should be sector ETF rather than particular stock.

I think that wikipedia author was thinking about them as 2 companies that dominate the sector.Something like BHP and RIO or Telstra and Optus in the statement above.

In one of Eric Sprott's videos Sprott talks about his recommendation of long/short funds rather than mutual funds.(video where he speaks to senators)

On other video he talks about how he is hedging his gold mining stock picks by shorting gold mining sector (I think it was the last video ).

His statement about hedging the industry risk was quite suprising for me.Because he is strong believer that gold will go up.

Bill Miller and Arnold Schneider heavy bet on housebuilder and subprime sector caused that their return is the worst from all gurus.

But would they be in the same mess if they short housebuilder sector f.e. ITB or subprime sector?

Try USG vs ITB ; ITB vs S&P ; USG vs S&P .

If I have 4 companies in 4 different sectors.(uncorrelated:) then shorting S&P makes sense,but with heavy bet on housebuilders and subprime sector shorting S&P instead of sector is nonsense.

Sounds so obvious? Bill Millers and Arnold Schneider don't think so. Laughing

PS:If you have any examples,ideas of your hedges .Please post them. 

  

 
By GordonGekko at Sun, 2007-11-25 23:11 | login or register to post comments

Changing the Bet

Pelcmareck,

I don't really look at pairs trading as hedging. I just look at it as a different type of bet. Instead of saying something will rise or fall absolutely, you're speculating that it will rise or fall in relation to something else. There are a couple of bets that I like:

Long Gold / Short the Dow

I like this because the Dow/gold ratio right now is about 16. When the US stock market bottoms, that should shrink to under 5. I would use GLD for the long position in gold and DXD to short the Dow. This is a very long term bet that I would leave in place for a number of years.

Long MSFT / Short Nasdaq 100

This one is a shorter term bet (less than 1 year). I think Microsoft will perform much better than the Nasdaq 100 over the coming months especially if the market is weak. Over the last month this would have been a very profitable trade. Here's how it would have played out last month with a $10,000 investment (assuming $25 per trade commissions):

Long position MSFT $6,641
Short position  QID $3,309
Commissions         $50

Total                     $10,000

MSFT 1-month return 6.6%. Position value is $7079.3
QID  1-month return 15.7%. Position value is $3828.51

If you closed out the positions on Friday, it would have given you a total of $10,857 after commissions for a return of about 8.5%

This trade looks like a good one to me over the next year as Microsoft is a strong company with a very cheap valuation in comparison to the rest of the Nasdaq.

All currency trades are essentially paired trades as you must necessarily sell one currency to buy another. The problem with paired trades is that quite often they are obvious like the Long MSFT; short QQQQ trade outlined above. When something is obvious, everybody jumps on board and then they try to exit the trade at the same time.

SunTzu
By Suntzu at Mon, 2007-11-26 00:20 | login or register to post comments

Suntzu


Beautiful and smart !!!!

Thanks,

Suntzu

By GordonGekko at Mon, 2007-11-26 02:23 | login or register to post comments