Posted on 08/30/2011
One strategy that allows you to approach the market in a "hedged" capacity is the "Pairs Trade" approach. We are all well aware of the many factors affecting the market environment, many of which can create cross-currents, so play selection is of paramount importance here with different approaches needed. That said, pairs trading allows us to approach the market in a bit more of a hedged capacity. So what exactly is pairs trading?
Essentially “pairs trading" is the process of buying one stock or ETF in a particular sector, or even asset class, then shorting another stock within the same sector. The goal here is to make money on both sides -- have the long position go up in price, while hopefully the short falls lower in price. However, unlike an independent equity position, a profit can be garnered by the spread working in our favor, if the long position simply outperforms the short. So the trade can be "successful" even if both rise, or both fall, provided one does so faster than the other. While this strategy can be applied to many different asset classes, today we will go over an example of potential pairs trades opportunities in the currency realm.
Investing in currencies is basically a pairs trade anyway. In order to buy one currency, you have to sell another - a pairs trade. One of the most efficient ways to do this is through buying and selling "cross-rates" in the foreign exchange market, but you can also take advantage of currency ETFs. One trend that we have seen developing across the currency market is a weak Dollar along with a lagging Euro and British Pound. A potential pairs trade using currency ETFs would be to short the Dollar, Euro, or Pound while buying a basket of stronger currencies, like the Australian Dollar or the Swiss Franc. Let's say you had $100,000 for garnering currency exposure. One could buy the ProShares UltraShort Euro ETF (EUO) as the short exposure. Given the strength of the other currencies, you could then buy the CurrencyShares Australian Dollar Trust (FXA), CurrencyShares Swiss Franc (FXF), and the WisomTree Dreyfus Brazilian Real (BZF) for the long side of the pairs trade. Since the EUO is double leveraged, we recommend putting 33% of the portfolio to work in the EUO and 66% among the FXF, FXA, and the BZF. The goal of this pairs trade is for the Euro to continue to depreciate while the FXA, FXF, and BZF continue rising in value.