Since the 1980s, one of the most well-known and heavily used
strategies among hedge funds and portfolio managers has been
#-ad_banner-#Classified as a market-neutral trading strategy,
pairs trades attempt to do away with the unpredictable up and
down moves of the overall market that often take individual
stocks with them. Instead, those who employ a pairs trade aim to
isolate the movement between two similar companies.
In a properly hedged pair, an investor goes long on one stock
and short on the other. Thus, when the market goes up, the long
position follows suit and profits, while the short loses money
(and vice versa when the market falls). The relationship between
the two stocks (known as a spread) will influence whether the
overall position prospers or not.
To profit from this strategy, you have to choose good pairs in
the same industry with similar business models and a consistent,
One of the most prevalent and oft-researched pairs
relationships has remained between the world's two largest
These two financial transaction companies are roughly the same
size, ($120 billion to $140 billion in market cap), engage in
comparable businesses, and have maintained a correlated (although
at times volatile) relationship for years.
Even if the market were to drop from here until
the end of the year, the pair relationship would most
likely hold, opening up the possibility to make money
even when the stock market falls.
While there are many ways to research and execute a pairs
trade, I find the basic dollar-weighted strategy to be the
easiest and most effective. If stock A is priced at $100, and
stock B is priced at $200, then one would employ a ratio of two
shares of stock A for each share of stock B. The goal is to get a
roughly equivalent amount of money into each side of the
A quick comparison of recent prices for both Visa and
MasterCard show that a ratio of 3 shares of MA for every share of
V gets roughly the same amount of capital invested on each side
(hence the "dollar-weighted" and "neutral" designations). For the
sake of simplicity, let's use recent prices for V and MA rounded
to the nearest dollar:
MA (our long): $73 times our ratio of 3 = $219
V (our short): $215 times our ratio of 1 = $215
Spread Price (3 * MA - V): $219 - $215 = $4
So what does all this mean?
By buying three shares of MA and shorting one share of V, a
savvy investor can forgo the stomachache of watching the market
rise and fall daily, concentrating only on the relationship
between Visa and MasterCard. This spread creates a chart of its
own ebbs and flows, typically bouncing off lows and falling from
established highs. Our current spread price of $4 shows that we
are on the low end of the pair's historical price. Just two
months ago, the spread price was around $30.
Holding from $4 to the recent high of $30, the position could
net a gain of nearly 6% in just a few months' time. While the
return isn't extravagant, the main attraction of the pair lies in
the downside protection if this bull market were to come to a
quick end. Even if the market were to drop from here until the
end of the year, the pair relationship would most likely hold,
opening up the possibility to make money even when the stock
Can you see now why this method has been popular with
investment banks and hedge funds for decades?
Just as with any other investment, company research and
following news is highly important. We recently saw how news
affected the pair positively late last week. On March 27,
levied a $5 billion lawsuit against Visa, accusing the payment
processor of setting excessive swipe fees.
As the market digested the news the following day, Visa fell
while MasterCard held even, causing the Visa short to profit
while MasterCard remained flat. As a result, the spread price
jumped from roughly $4.50 to $8 in just one day.
Risks to Consider:
Pairs trading is not without its own caveats. Unexpected
events in the underlying stocks could sway prices strongly in
favor or against an investor. Also, pair relationships can break
down over time due to competition, weakness in performance, poor
earnings, and so on. Tread softly and use pairs primarily as a
tool to hedge market risk.
Action to Take -->
The Visa/MasterCard pair is settling at historical lows and is
ripe for the picking if the ratio price (calculated above) can be
had under $8 to $10. However, if the price falls under $1 to $2,
it may signify that the pair relationship is breaking, and it may
be time to exit and seek other opportunities.
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