Pairs Trading: Market Neutral Investing

The concept of market-neutral investing is relevant because pairs trading is a market-neutral strategy. In his 2000 book “Market Neutral Investing: Long/Short Hedge Fund Strategies,” Joseph G. Nicholas, founder and chairman of HFR Group, wrote: “Market-neutral investing refers to a group of investment strategies that seek to neutralize certain market risks by taking offsetting long and short positions in instruments with actual or theoretical relationships. These approaches seek to limit exposure to systemic changes in price caused by shifts in macroeconomic variables or market sentiment.” (See also: Top 5 Books to Learn About the Hedge Fund Industry.)
 
Market-neutral investing is not a single strategy. Numerous market-neutral strategies include:

• Convertible arbitrage
• Equity hedge
• Equity market neutral
• Fixed-income arbitrage
• Merger arbitrage
• Mortgage-backed securities arbitrage
• Relative value arbitrage
• Statistical arbitrage (“StatArb”)

The various market-neutral strategies invest in different asset types; for instance, convertible arbitrage takes long positions in convertible securities and short positions in common stock. As another example, merger arbitrage takes long and short positions in the stocks of companies involved in mergers. Market-neutrality can be achieved either at the individual instruments level or at the portfolio level. While the strategies are very different – both in terms of assets and methodology – they all fall under the market-neutral umbrella. This is because each derives returns from the relationship between a long and a short component – either at the individual instruments level or at the portfolio level. (See also: Introduction to Order Types: Long and Short Trades.)

How market-neutral relates to pairs trading

Because one position is taken in conjunction with another position to reduce directional exposure, market-neutral strategies often provide a hedge against market risk. In this manner, exposure to the market is exchanged for exposure to the relationship between the long and short positions. This doesn’t imply that market-neutral investing is risk-neutral or even risk-free (it’s neither); however, the risks are different than those associated with directional, long-only investing. A market-neutral approach provides an alternative and uncorrelated source of returns when used as part of (but not as a substitute for) an overall investment strategy. (For more, see: Hedging Basics: What is a Hedge?)
 
Pairs traders limit directional risk by going long on one stock (or some other instrument) in a particular sector or industry, and pairing that trade with an equal-dollar-value (or dollar neutral) short position in a correlated stock (for example, long $10,000 on stock A and short $10,000 on stock B, typically within the same sector or industry. Because it doesn’t matter which direction the market moves, directional risk is mitigated. Profits depend on the difference in price change between the two instruments, regardless of the market’s direction, and are realized through a gain in the net position.