A Primer on Pairs Trading: Coke and Pepsi

If you don't get "pairs trades," you're not the only one. Trading stocks in pairs is one of the trickier investment strategies out there, but it doesn't have to be. Here's a look at how to trade pairs, and other ways you can "pair off" your investments to reduce your portfolio's risk.

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.

« Previous Page

1 2

Next Page »