A few years ago, a German billionaire had a go at pair trading with Volkswagen’s two share classes. He ended up jumping in front of a train.
The pair-trading strategy — essentially buying one stock while selling short another within the same sector — sounds good in theory, but it can be a real portfolio killer.
Here’s how it works: When you pair trade stocks, you buy the underperformer, and you sell the outperformer. You are betting on mean reversion. In other words, you think the stock that has fared relatively badly will make up for that over the next period and start outperforming the one that had done well.
In the oil sector, for example, think Exxon Mobil XOM, -2.26% vs. Royal DutchRDS.A, -2.28% whilst in the health-care sector, it would be something like GlaxoSmithKline GSK, -0.88% vs.Pfizer PFE, -0.06%
It is a popular strategy, and the opportunity can be easily spotted on a chart where both stocks are plotted versus each other, i.e. a relative chart.
Here you can see the chart of consumer goods company Unilever UN, -0.49% vs. its peer Procter & Gamble PG, +0.42% This is a 3-year chart, and when the line has gone up it means Unilever outperformed Procter & Gamble, and when the line has gone down, Procter & Gamble outperformed Unilever.
They have been stuck in a tight range. They are two well-managed global in a very stable sector, so when one stock underperforms, the other company should catch up sooner or later. Seems easy enough!
Unfortunately, the reality is that I have seen a lot of people do this kind of pair trading over the past 20 years, but not met any individual traders who have consistently made money doing it. It might be different for computer programs, which trade intraday, but for people without that kind of computer power, it is a loss-making strategy as far as I am concerned.
Why do I think that is the case? Well, first of all, there is normally a good reason why a certain stock outperforms its competitor over a certain period. It might well be a fundamental change in the business, or maybe new management has arrived, or perhaps the two stocks weren’t as comparable as first thought.
Let me give you an example of a pair trade that went terribly wrong.
Here you see the price ratio between General Motors GM, -2.82% and FordF, -1.72% between 2002 and 2012. You could argue that they were trading in a range between 2002 and 2008, and if you had enough patience a pair trading strategy would have made money.
However, it would have given you the position in 2008 of being long the underperformer General Motors vs. short Ford Motors, at a ratio of between 2.5 and 3.That position would have lost you all your money as the ratio went to zero when General Motors went bankrupt in 2009. So it really would have been a bad strategy to bet on the underperformer being the place to put your money.
Other issues with pair trading are that you pay a lot of commission to your broker, and that the time period of mean reversion might be much longer than you initially hoped for. Also, as the spread goes out further and further, more and more traders will put on this trade just as you did, leading to an enormous consensus position, where all the traders are on the same side of the trade and are all losing money and getting nervous.
The chances are that the spread will go out even further as these traders start to cut their positions.
If pair trading can drive a billionaire to suicide, I think that tells you that you should stay away as well. My recommendation: Keep your life simple — don’t do pair trading.