Long/Short Equity: An Introduction to Pair Trading Strategies

Evan Ratner |

Long/Short Equity also known as pair trading is the strategy of trading two securities simultaneously, one long and one short.

Long / Short Trading was developed as a strategy that seeks to generate significant and consistent returns while controlling risk by maintaining a low correlation to broader market averages.

Long / Short trading is a market neutral strategy. The strategy is uncorrelated to the broader market and should profit regardless of whether equities rise or fall.

Long/Short Trading Strategy

The strategy behind long / short trading is to find similar assets with dissimilar valuations. This is done by analyzing companies that are relatively similar (same industry or subsector) and correlated but are valued differently by the market. Investors would then buy the cheap asset while selling the rich asset playing for a convergence in value.

Long/Short trading is a strategy implemented by many investors and hedge funds. Julian Robertson founder of Tiger Management popularized long short trading. His funds mandate was to find the 200 best companies in the world and invest in them, and find the 200 worst companies in the world and short them.

Mean reversion is a part of long short trading strategy. For example if a pair of two highly correlated assets historically traded in a tight range but now trades one or more standard deviations away from historical means. A trader would look for a pair to revert to the mean.

Popular valuation metrics to analyze and compare companies are:

  • Price/EarningsPEG

  • Dividend Yield

  • Price/Book

  • Enterprise Value (EV)/EBIT

  • EV/EBITDA

  • EV/Sales

Other factors when selecting pairs

  • Volatility

  • Volume

  • Sector

Dollar Neutral Trading

Long Short trades can be constructed in a dollar neutral manner, which requires employing the same amount of capital on the long and short side. This means that the purchase the long shares will be paid for with the proceeds of the shares sold short.  In a dollar neutral trade the amount of capital employed will be equal but the shares bought and sold short will not be equal.

Popular Pair Trades

A question most asked is what stocks are most suitable for pairs trading. What makes long short trading such a popular strategy is that there are infinite combinations of ideas. Any two stocks can be used long or short in a pair trade.

Some popular pair trades are two similar companies in the same sector such as

  • ATT (T) vs Verizon (VZ)

  • Bank of America (BAC) vs Citi (C)

  • Visa (V) vs Mastercard (MA)

A graphical representation of a dollar neutral pair trade: Long T and Short VZ. In this example an investor who creates a dollar neutral pair by shorting .71 shares of VZ for every 1 share of T bought. The investor would look to profit $2.37 if the pair reverted to its historical mean.  

 

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
ATOA Altovida Inc 0.08 0.00 0.00 0
BAC Bank of America Corporation 15.65 0.49 3.23 119,428,684
C Citigroup Inc. 47.23 1.43 3.12 25,563,084
MA Mastercard Incorporated 101.77 1.16 1.15 5,503,915
T AT&T Inc. 40.61 -0.12 -0.29 19,381,624
V Visa Inc. 82.70 0.78 0.95 9,776,837
VZ Verizon Communications Inc. 51.98 -0.14 -0.27 13,077,552

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