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When it comes to trading in the kind of market we find ourselves in today — where it’s up, then it’s down then it’s up again — where there’s no clear trend, pairs trading can be a solid strategy to minimize risk while staying active in the market.
But if you’re just starting out, you might be wondering: What exactly is pairs trading?
In simple terms, pairs trading involves buying one stock (going long) and selling another stock (going short) at the same time. These stocks are usually in the same sector or industry, like two energy companies or two tech giants, because their prices tend to move in similar directions.
Why would you trade a pair instead of just betting on one stock? It’s about hedging your risk. In pairs trading, even if the whole market turns against you, one stock might go up and the other might go down, which can limit your losses while still offering upside.
Now, let’s dive a bit deeper into why this strategy works and how you can use it effectively.
Why Do Pairs Trades?
The biggest advantage of pairs trading is that it’s a hedged strategy.
Think of it this way: when you buy a simple call or put outright, you’re banking on the market moving in just one direction.
Meanwhile, pairs trading allows you to profit from price differences between two related stocks, regardless of which way the market moves.
For example, let’s say you buy a call on a stock that you think is going to go up. At the same time, you buy a put on another stock in the same sector, but one you think might underperform.
If your bullish stock takes off, you make money on that call. If your bearish stock drops, you make money on that put. The idea is that you’re always hedged — whether the market goes up or down, one of your trades should pay off.
In a volatile market like we’ve seen lately, where one day’s winner can be the next day’s loser, this strategy can help smooth out some of the uncertainty.
What Happens if Both Stocks Move the Same Way?
This is a common question, and it’s important to understand.
If both stocks in your pairs trade move in the same direction, you’re still not losing out entirely. Here’s why: one stock will likely move more than the other, meaning you can still profit from the relative difference in their performance.
Say you bought a call on Stock A and a put on Stock B. If Stock A shoots up while Stock B also rises, you’re making more money on Stock A than you’re losing on Stock B because Stock A’s call gains intrinsic value, while Stock B’s put loses only time value.
Remember, it’s all about movement. You don’t need both stocks to perform in opposite directions to make money. As long as the stocks don’t move perfectly in sync, you can still come out ahead.
Wrapping It Up
So whether you’re dealing with a choppy market or just looking for a more hedged approach, pairs trading could be a smart strategy to add to your playbook.
It’s about managing risk and taking advantage of the relative movement between stocks, even when the market’s all over the place.
Stay tuned for tomorrow where I’ll dive deeper into how to use pairs trading in different market environments and things you should watch out for if you’re just getting started with pairs trading.
— Geof Smith
P.S. Are you ready to trade the 2025 Uranium Boom? Click here to get my top Uranium play!
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