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A Primer on Pairs Trading: Coke and Pepsi

Jonas Elmerraji

What's a Pairs Trade, Anyway?

Twenty years ago, the term "pairs trade" wasn't something you would have read about in your favorite investing publication. That's because until not so long ago, it was a strategy Wall Street traders kept close to their chests.

Trading pairs was developed by quantitative analysts at Morgan Stanley (MS Quote - Cramer on MS - Stock Picks) in the late 1980s. Ever since, pairs trading has become a popular technique in the professional investing world. And when online brokers became popular in the mid-1990s, so too did pairs trading -- as a way for in-the-know investors to rake in some nice returns without exposing themselves to market risk.

So how does pairs trading work?

When you trade pairs, you're basically playing with the spread between one stock's price, and the price of a related stock. One of the central concepts of pairs trading is the fact that some investments -- like two stocks in the same sector or industry -- have prices that are highly correlated with each other.

A Look at Coke and Pepsi

When it comes to pairs trading, check out Coca-Cola (KO Quote - Cramer on KO - Stock Picks) and PepsiCo (PEP Quote - Cramer on PEP - Stock Picks). Company news notwithstanding, the fates of the two soft-drink giants are fairly intertwined because they're very similar companies. Because of this, so too are their stock prices:

Source: TheStreet.com

Click here for larger image.

Since historically, prices of correlated companies like to stick together, pairs traders take advantage of the times when those prices diverge from each other more than the norm. Pair traders short the high stock and go long on the low stock, so that when the prices converge again, they're getting gains from both sides.

Going back to our example, if Coke's stock price is higher than it historically should be in relation to Pepsi, an investor could take a short position in Coke, expecting it to fall to meet Pepsi, along with a long position in Pepsi, expecting it to rise to Coke.

Why Pairs Trades Work

Trading pairs is an effective investment strategy for a couple of reasons. For one, it's very quantitative, meaning that you don't need Warren Buffett's business acumen to make a good pairs trade. Another reason pairs trading is effective is the fact that it leaves you with a "market-neutral" position. In other words, the ebb and flow of the market doesn't affect your investment.

Let's go back to the quantitative side of pairs trading. One of the beauties of trading pairs is the fact that -- unlike many investing strategies -- intuition doesn't play much of a role. In fact, large investment houses use high-powered computers to construct and execute pairs trades automatically using complex algorithms.

Again, a major reason that pairs are effective is the fact that a pairs trade is market-neutral, which means that the way the market moves won't impact your money. Let's go back to the Pepsi/Coke example. If the market goes caput, your losses on the long position in Pepsi are going to be offset by the returns you'll make from your short in Coke. With pairs trades, it's the stocks themselves that matter, nothing else.

Using Hedges for Your Investments

Pairs trading works partly on the concept of hedging , but pairs aren't the only way to limit the impact of the market on your portfolio. By insuring your investments against market movements, a technique known as hedging, you can unleash a world of return potential for your portfolio.

A hedge is any investment that cancels out the risk of another investment. If you're long a stock because you think it will outperform its peers, shorting one of those peers is a good way to protect against market volatility . So if the market sheds 5%, your short position gains cancel out the market, and if it rises 5%, your long gains cancel that out. This way, the only thing that affects your portfolio's bottom line is the performance of that stock you've picked.

Quite a Pairing

There is huge gain potential in pair trades, mostly because many individual investors just don't understand how they work -- this type of trading is one of the more complicated investment techniques to execute well. While this article breaks down the basics, if you want to get more in-depth, check out the book Pairs Trading by Ganapathy Vidyamurthy.

Hedging, though, doesn't have to be as complicated. There are a lot of ways to hedge your investments, no matter what your portfolio looks like. For more on how to hedge, read "Advice on Short-Selling, Volatility" and "Five Arbitrage Techniques Every Investor Needs to Know."