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Accounting & Finance

Why Long-Short Equity Trading Pays Off In Volatile Markets

By a Verblio Writer

(925 words)

Imagine you’re cruising on one of those racing, motocross motorcycles, weaving through that slow-and-go traffic, reaching your destination hours ahead of all those stuck SUV-drivers.

Your ability to move nimbly on that small but high-powered vehicle gives you an advantage on traffic-clogged freeways much as pair trading as a solo investor allows you to move nimbly through the stock market, making money ahead of the big boys. Of course, you’d love to beat the big boys on Wall Street. We can help you get there by showing you how long-short equity trading pays off in volatile markets.

Understanding Long-Short Equity Trading

First, you need to understand what we mean by long-short equity trading, also known as pair trading, pairs trading, statistical arbitrage, and relative value arbitrage. From here on out, we’ll keep it simple and refer to it as pair trading.

Pair trading has been around the markets for about 60 years and is widely used by hedge funds, institutions and other market investors. It’s only been since the outset of the 21st century that small traders have had access to the necessary tools to become successful as pair traders.

The basic concept of pair trading is that you monitor pairs of similar stocks and if their values begin to diverge, you assess whether the underlying reason is fundamental or accidental. If there is no valid reason for the stocks to diverge, you know it’s some kind of fluke and the market soon will correct itself and the stocks will reach similar values again, usually pretty quickly. If that’s going to happen, you have your chance to make money by buying long and short on the two stocks, exiting the deal when they return to their stable positions.

How Does Pair Trading Beat Volatility?

Next, we’ll look at why pair trading is especially effective in volatile markets.

Keeping your emotions out of your trading during volatile market times is the biggest challenge most traders face.

Of course, you’re excited to make those huge payoffs when you bet the right direction, but you’re also likely to get scared, run off and hide when you suffer the big losses.

Pair trading is a great strategy during volatile times as it allows you to remain in control of your investments, lower your risk, and still make money ahead of the market indexes.

Let’s look at three reasons why.

• Not riding the market wave

When you are pair trading, you have no real interest in what the rest of the market is doing. Your investment is keyed into only two similar stocks, so as they move with the market, you’re merely waiting for them to meet back at their stable place in the middle.

You’re making money whether they are going up or down, as long as they are drawing closer together.

• No emotions

When pair trading, you are working a system, so you don’t need to get emotional about your trades and panic when they’re not going your way. Because you have a short- and long-sell paired together, you can easily ride it out until the payoff comes.

• Many eggs

The best strategy for operating pair trading is to make small investments in many pairs of stocks, spread over as many sectors of the market as possible. Of course, you’re going to feel more confident in some sectors than others, so your portfolio may not span the spectrum, but still, you will feel more stability even if one pair fails to return to center.

Pair Trading Toolbox

Finally, let’s look at the tools you can use to enter the pair trading strategy.

While you’ve gained a little better understanding of pair trading, the best way to gain knowledge and confidence in your ability to beat the market indexes is to get right in there and do some trading.

Well, you may want to do some paper trading to begin with until you feel like you’ve gotten a handle on things. Once you’re ready to get serious about pair trading, here are some tools that will help you do so profitably.

Analytics Program

Many solo investors believe they can do everything on their own with free websites, spreadsheets, and other sources, but a truly successful pair trader understands spending all that extra time on research and crunching numbers is costlier than paying for analytics services.

Remember our example from the beginning of this series about the nimble motorcycle rider gliding through stalled traffic. A service that can provide you potential pairs, alert you when they are diverging, automatically give you the charts on ratio, RSI, correlation, and volatility, will give you the nimble edge to get ahead of the competition.

The most successful strategy for successful pair trading is a diversified portfolio, so the faster you can move when trade opportunities arise, the more trades you can make and the more successful you will be.

A Reliable Online Broker

The other piece of that equation is having an online broker with reasonable fees and one that makes your transactions in a timely manner.

Pair trading frequently means a quick exit from a stock holding, so you don’t want to be stuck paying high broker fees for short-held stocks.

Your profit margins also are going to be best when you time your trades, so you want to be sure your broker can make the transactions in real time.

Following the practices you learn through our website and using our reasonably priced analytics software offers you the best opportunity to succeed as a pair trader. Visit our website today to learn more.

Questions? Check out our FAQs or contact us.