How to manage your risk by using a pairs strategy

MARKETS are fraught with uncertainty: the fiscal cliff, conflict in the Middle East, the Eurozone crisis, and slowing growth in China are just some of the problems that could potentially derail equity markets. Therefore, traders must use risk management techniques to mitigate their risk exposure.

But if investors suddenly sought safety by moving their money out of equities and into cash, for example, the resulting sell-off may have a sharp impact – regardless of the stock’s (or sector’s) ability to outperform the market. This begs the question: what is the best way to protect yourself?

To illustrate one risk management technique, we could use the example of a fictional retailer – Retailer Plc. The company’s stock has performed well recently. It has a diversified, global customer base, and the absence of high street shops keeps its costs low. The firm is expected to put in a solid performance over Christmas. However, if there is a concerted move out of equities, how can you protect your position in Retailer Plc?

Consider two scenarios. In each case, Retailer Plc outperforms the market by 5 per cent.

SCENARIO ONE
Retailer Plc’s stock rises by 10 per cent, and the index (the FTSE-100) rises by only 5 per cent. The price you are quoted for Retailer Plc is 2,205p-2,217p and the price of the FTSE 100 is 5,653-5,654. To offset our risk exposure we should trade both the index and Retailer Plc.

If we expect the firm to outperform the market, we could go long on Retailer Plc at £5 per point, and short the FTSE 100 at £2 per point. We close our positions at 5,938-5,939 for the FTSE (a 5 per cent gain) and 2,425p-2,437p for Retailer Plc (a 10 per cent gain), making a profit of £1,100 on Retailer Plc (2,425p-2,437p x £5 = £1,100) and a loss of £572 on the index (5,653-5,939 x £2 = £572). Our total profit is £528.

SCENARIO TWO
In the second scenario, investors move their money out of equities and into cash (the flight to safety). The FTSE 100 drops 10 per cent to 5,088-5,089, while Retailer Plc trades 5 per cent lower at 2,095p-2,107p.

We close our positions and make a £572 profit on the FTSE 100 (5,939-5,653 x £2), and a £610 loss on Retailer Plc (2,217p-2,095p x £5). Our total loss is £38.

Although our strategy has minimised our potential gain, if we had not made this “relative out-performance” bet and hedged our position in both scenarios, we would have been left with a significant loss.

Given the uncertainty that currently exists in the market, this sophisticated approach is a useful tool for managing your trading risk properly. However, it should not be seen as a substitute for placing stop-losses and limit orders, which are also vital risk management tools.

The pairs-trading technique can easily be applied to a single company and its parent sector, or even a company and one of its peers within the sector – for example, Ryanair and IAG (the consolidated group of British Airways and Iberia).

For this strategy to work effectively, you must ensure that your absolute exposure – the price of the stock multiplied by the size of the bet – is broadly in proportion on both sides of the trade.