In this period of market uncertainty, some investors may want to consider pair trades as a hedging tool. The idea behind this particular type of trade is simple: You select two highly correlated stocks and buy one and sell short the other. The idea being that if markets or that industry go sour, the gain from the shorted stock will offset or lessen the loss from the long position. Conversely, if the stocks rise the long position helps shield the decline in the short position.
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Pros and Cons
Clearly, pair trade hedging is not a clean bet nor are there any guarantees. Mr. Market can suddenly have a mind of his own and send stock prices in all kinds of mystifying directions. That being said, over time, stocks tend to fall in line with their correlation patterns. Another concern to be aware of is that just because it's a "hedge" pair trade does not meant you will not lose money. If you go long A and short B and A declines 10% while B declines 5%, your net result is a 5% loss. Indeed it's a lighter loss than the 10% had you only been long A, but it's a loss nonetheless. In any regard, pair trades usually don't comprise the entire portfolio unless it's a specific fund that has that express purpose in minds. (For more, see Finding Profit In Pairs.)
Potash Pairs to Consider
So for example, the M&A buzz currently surrounding the fertilizer space has provided a nice lift to most industry participants. For those who think share prices have gone up too quickly, a long/short pair trade may be just the fit. For example, both CF Industries (NYSE:CF) and Mosaic (NYSE:MOS) have experienced share price advances greater than 20% in less than two months. A long/short position among these two names would provide relief in case the industry faces a rapid pullback due to the overall market or a change of market sentiment for the industry.
Fashion Hedge
Despite overwhelming data that consumers still remain very cautious, retailers are being priced as if all is well. Teen retailer Abercrombie and Fitch (NYSE:ANF) trades for 33 times earnings in an extremely competitive industry. It's constantly competing with the likes of American Eagle Outfitters (NYSE:AEO), The Gap (NYSE:GPS) brand of stores and numerous others for the teen shopping dollar. In the meantime you have ultra discount retailers like TJX (NYSE:TJX) that benefit from selling name brand merchandise at discounted prices and trades for 12 times earnings. A long position in TJX coupled with a short of Abercrombie may be a suitable option for a pair trade.
Not for Every Investor
Pair trades are not designed for huge gains or all portfolios. The best investment philosophy will always continue to be the careful selection of quality stocks trading at decent prices and holding on until the price no longer reflects a good value. Yet in these uncertain times, pair trades can provide some decent insulation for some portfolios. (For related reading, see Give ETF Pairs Trades A Chance.)
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