The concept of pairs trading is to purchase, for example $100,000 worth of stock, and at the same time, shorting $100,000 worth of another stock. Before we look at how practically we could place a trade like this, it is worth looking at a few charts of pair trades that show up some interesting technical patterns.
Westpac and National Bank are similar in share price but over the past 12 months have ranged traded between the same price and a $2-dollar difference.
Commonwealth Bank previously appeared to be the preferred bank amongst the major banks but in the last couple of months the sentiment appears to have waned.
Going long Macquarie Bank against any other bank would have been a safe bet over the past 12 months.
The idea is to go long and short stocks in the same industry to remove directional bias of the sector, ie in this case you should just be short the major banks. Pairs trading allows you to profit from the least bad stock.
To place a pairs trade, you could use mini warrants to go long and short the different stocks.
For example, to go long $100k worth of WBC stock (previous close $26.50), you could buy 3773 WBCKOI (Mini long strike $21.995) at the close price of $4.51 – cost $17,016.
To go short $100k of NAB stock (previous close $25.210), you could buy 3966 NABKCV (Mini short strike $29.23) at the close price of $4.64 – cost $18,402.
Here are some considerations if you chose to trade mini-warrants. The funding costs involved in holding mini-warrants can be prohibitive if the position is held over a long period, so you would need to set a time stop if your predicted share price move does not eventuate. An overall rising or falling market could also trigger a stop loss in either stock, so that risk would also need to be managed. You would need to become familiar with the risks of these instruments and use the assistance of your adviser to place the trades.
Below are charts of examples of pairs trades where you go long shares (buy $100,000 of stock divided by the current share price) and you go short shares (sell $100,000 of stock divided by the current share price) and charting the difference in value.