A Primer on Pairs Trading: Coke and Pepsi

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."

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