Changing market conditions often have a sector-wide impact, affecting the profit and loss (and therefore share price) of numerous companies at the same time.
It is not uncommon, therefore, to see the share price of direct competitors such as Coca Cola and PepsiCo or Yahoo and Google moving in the same direction, giving the impression their share price movements may be related.
Pairs trading is a popular strategy that generates low-risk profits by exploiting the trading pattern between the shares of similar companies without taking a view on the overall direction of the market.
What is pairs trading?
It stands to reason that general economic vagaries that affect the profit and loss (and therefore the share price) of Coca Cola will often impact PepsiCo in a similar way.
Sometimes, however, market conditions may result in a breakdown in the share price co-relation between two companies, thus widening or narrowing the historical price ratio relationship between the two.
This breakdown in price co-relation can be caused by rational, fundamental factors (an economic situation that affects one company but not the other, for example) or by a set of irrational factors such as panic-selling or trader bias.
Pairs traders assume that the latter, owing to its irrational nature, causes only a temporary discrepancy in price movement between co-related shares and the historical price relationship between the two securities will, therefore, be restored with time.
How pairs trading works
Once the historical price ratio changes between two highly co-related companies, assuming that this is a transitory inconsistency, one company can be perceived as being 'undervalued' and the other 'overvalued'.
With pairs trading, you can profit from such situations by exploiting the price divergence between two shares. This can be done by placing a long position on the 'undervalued' share and, simultaneously, placing a short position on the 'overvalued' share, with the intent of taking profits when the price ratio between the two securities converges back to its historical level.
Pairs trading with IG Index
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