How To Implement The Pair Strategy
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I have received tons of interest on my pair trading article and the play I entered in both Apple and Research In Motion. I went long Apple and short Research In Motion.
The strategy of matching a long position with a short position in two stocks of the same sector is called pair trading. This creates a hedge against the sector and the whole market that the two stocks are in. The hedge made is really a bet that you are placing on the two stocks; the stock you are long in opposed to the stock you are short in.
As its name implies, a pair trading tactic is a double-pronged method, where 2 seemingly unrelated option or stock positions are entered simultaneously. The strategy can offer somewhat of a safety net to defend against an unforeseen move in a explicit sector, while capitalizing on a particular equity's relative-strength backdrop.
Fundamentally, a pair trader hedges his or her bets, opening positions in two connected equities or indexes and playing them against one another, choosing 1 call (bullish) position and 1 put (bearish) position. The pair of positions then collectively gives money-making returns in the midst of a number of outcomes.
For instance, I had a good view regarding Apple, but a negative sentiment concerning Research In Motion. I went long on Apple while I shorted Research In Motion.
I moreover had an uneasy sentiment about the entire tech sector. By taking a short position in Research In Motion, it allowed me to profit if a broad sell off in tech took place. This profit on the short side would offset my losses in Apple on the long side.
Apple maintained its relative strength versus Research In Motion. The shares rallied and the short side of the trade (Research In Motion) fell. Both sides of the paired trade enter positive territory.
But let us say the entire technology sector suffers a large decline. The Research In Motion short is profitable, counter-acting the Apple long position which nets a loss. This is a better outcome than if I just went long on Apple.
You are looking for the percentage change in the market between Apple and Research In Motion to move in Apple's favor no matter which direction Apple or Research In Motion head.
On May 14, 2009, I went long Apple at 122, and short Research In Motion at 71. I exited out of the trade on July 10th 2009 with Apple at 137 and Research In Motion at 66. I nailed 12% on the AAPL long, and 7% on the Research In Motion short. Hence the total gain was 19%.
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