Imagine you have found a stock you think is likely to rise relative to the overall market – possibly because it is either technically oversold and/or fundamentally cheap. To trade this view, you could simply buy the stock outright, though that opens you up to the risk that its price could still decline during a market sell-off. To hedge against this risk, the alternative would be to enter a “pair trade” whereby you also buy the stock outright, while also simultaneously taking a short position against the overall market. While usually the domain of sophisticated and institutional investors, exchange traded products are an effective tool to allow individual investors to implement such trading techniques. Here’s how.
Stock vs. Market Pair trade using the “Bear” Hedge Fund
Imagine you expect the overall equity market to enter into a period of sluggish price growth or even price declines. In this environment, you might also expect relatively “defensive” stocks such as Telstra to outperform. For example, in the two months from 13 October 2014 to 15 December 2014, the S&P/ASX200 traded largely sideways, rising by only 0.6%. During this same period, shares in Telstra rose by 9.5%. If you felt Telstra’s price was likely to continue to outperform, you could implement a pairs trade by shorting the S&P/ASX200 and buying Telstra shares.
But how does one short the S&P/ASX 200 in a simple way?
To get short exposure to the S&P/ASX 200, an investor could use the ASX-traded “BEAR” fund – which short sells the S&P/ASX 200 SPI futures contract. This means the price of the BEAR fund is expected to move up when the S&P/ASX 200 falls (and vice versa). Importantly, compared to short selling the physical shares or futures contract directly, the BEAR fund does not impose any margin call requirements on investors (all margin call requirements are met within the fund).
Returns of the BEAR Fund After Fees – 31 March 2015
Past performance is not an indicator of future performance. Returns are calculated in Australian dollars using net asset value per unit at the start and end of the specified period and do not reflect brokerage or the bid ask spread that investors incur when buying and selling units on the ASX. Returns are after fund management costs, assume reinvestment of any distributions and do not take into account tax paid as an investor in the Fund. Returns for periods longer than one year are annualised. Current performance may be higher or lower than the performance shown.
The BEAR fund can be used to short sell the broad market, and provides a simple and convenient way to assist in the implementation of a pairs trading strategy – great for investors that have strong views on individual shares or sectors and their relative price movements compared to the broad sharemarket.
It should be noted that the BEAR fund is managed actively and should not be expected to provide the exact opposite of the market return over any time period.
Sector vs. Stock Pair Trade using a Sector ETF
For investors with access to stockbrokers providing short selling services, another pairs strategy could be used to take a view on a stock’s performance relative to that of its relevant sector. For example, if you believed BHP’s share price was likely to underperform the overall Australian resources sector, you could short BHP through your stock broker and buy a fund which provides broad sector exposure, for example our Resources Sector ETF (ASX: QRE).
While the premise of pairs trading is simple – simultaneously buy and short sell different shares or indices, there are more advanced pairs trading strategies which look at hedging or managing volatility. We’ll have examples of how to execute these pair trading strategies in later Blog posts.
Of course, pairs trading may not be for everyone and we recommend you consult a licensed financial adviser before implementing any investment strategy.