How Does A Pairs Trade Work?

One of the best ways to create more portfolio balance during volatile times is to engage in pairs trading. Pairs trading represents a plan for hedging the risk of trading stocks by opening opposing positions in 2 related stocks.

This strategy allows you to potentially profit, regardless of market conditions. While pairs trading was traditionally set up for long-term stock investments, investors with shorter timescales can also take advantage of this trading strategy.

How Pair Trading Mitigates Risk

To perform a pairs trade, you need to identify 2 stocks positively correlated in price. When you pair trade then, you normally seek two same-industry stocks.

A pairs traders buys one stock and shorts the other, creating a neutral position overall if correlation remains the same as it has done historically.

When the correlation breaks down, opportunity arises. The trader can place the position in expectation that the old correlation will re-establish itself. 

Under the idea of neutrality, a stock investor anticipates that an underperforming stock will ultimately return to a neutral position, which triggers a price increase while an overperforming stock will eventually experience a price decrease. As a result pair trading, when performed correctly, mitigates risk.

This is because an investor can still profit if only one of the stocks moves. For instance, if an overperforming stock does not decrease in price and an underperforming stock rises more than the rising share price of the overperforming stock, the trader who is short the overperforming stock and long the underperforming stock can realize a net profit.

Or, if the trader is long the underperforming stock, which still underperforms, and short the overperforming stock which then plunges in price, the trader can receive a profit on the short stock position.

Therefore, you can profit in one of 3 ways from a pair trade.

1. Both stocks move as projected.
2. Only the long stock moves as predicted, but is more profitable than the short-traded offset.
3. Only the short stock moves as projected, but is more profitable than the long-traded offset.

Correlated Stocks to Use for Pairs Trading

One of the best ways to facilitate pairs trading is to invest in steel, especially now. Two correlated stocks that work well for this trade include Nucor (NUE)  and Schnitzer Steel A (SCHN), both which, when combined in the same portfolio, diversify away stock market risk. Both are steel stocks and considered cyclical. Therefore, using stocks in this industry for pairs trading can prove to be profitable.

As noted, the correlation between a pair of stocks is the key to pairs trading. Stocks are perfectly correlated when they move in sync (at a coefficient of 1) and inversely correlated when they move in opposite directions but still in sync (at a coefficient of -1). If stocks do not have any correlation between them, their coefficient is 0. Usually investors use a cutoff value of 0.8.

For pairs trading to succeed, there has to be a reason for the correlation. For example, a relationship needs to exist that binds the 2 stocks. Therefore, the stocks are usually 2 direct competitors or 2 stocks in the same industry. Before we analyze the pairing of Nucor and Schnitzer, it is important to learn about divergence.

The Divergence Between 2 Paired Stocks

When stocks have a high degree of correlation, certain factors may influence one of the stocks but not impact the other stock.

These factors cause a divergence between the 2 correlated stocks and may be represented by:

• Earnings Reports
• Mergers and Acquisitions
• Leadership Changes
• New Product Releases
• Changes in Dividend
• Internal Events in a Company that Do Not Impact a Sector Overall

Divergence is what causes you to invest in one stock for the long-term and another stock for the short-term in a traded pair.

Pros and Cons Of Pairs Trading

Remember: A long pairs trade minimizes risks in a bull market while a short pair trade reduces risk in a bear market. What is great about pairs trading is that a trader can potentially profit in any type of market – whether conditions are volatile, stable, moving sideways, losing or gaining.

One of the major drawbacks of pairs trading is making an assumption about movement. For example, stocks don’t always return to their correlated relationships after a divergence.

That’s the inherent risk found in this type of trading strategy. How the stocks have moved historically does not mean they will do the same in the future.

Why Nucor and Schnitzer Are an Ideal Pair

To understand the correlation between Nucor and Schnitzer Steel A, let’s look at a brief overview of each company. From data on the web, Nucor Corp will experience good financial stability over the coming few years. Also most of the company is owned by institutional investors.

Schnitzer Steel A (SCHN), on the other hand, has experienced a high volatility, historically, over the past 90 days. However, it looks like the stock will perform well in a bear market as an offset to Nucor’s more bullish disposition. The company’s alpha is 0.4469, which implies the company can generate a .45% excess return over DOW after adjusting for the inherited market risk (beta).

Yahoo Finance gives an A rating to Nucor for being a momentum stock – something to invest in for long-term gains. Momentum investing, in a long context, involves buying high with the hopes of selling higher.

While momentum investing does not advocate buying low and selling high, momentum investors normally do not wish to place their money into cheap stocks while waiting for them to recover over the long haul. Instead, they believe buying a stock at a high share price and selling higher makes them more money in a less amount of time.

Nevertheless, the idea behind a momentum stock is often lost once a stock’s valuation overtakes its growth potential. That’s why pair trades are important to those who favor momentum type stocks.

According to Yahoo Finance, Schnitzer is a fast-moving stock that is still attractively priced. With respect to movement, SCHN has a beta of 1.37, showing that it moves 37% higher than the market in each direction.

More About Nucor

Based in Charlotte, North Carolina, Nucor (NUE) is the largest steel manufacturer and mini-mill steelmaker in the U.S. The company uses electric arc furnaces to melt steel versus blast furnaces, used to melt iron.

Nucor is one of the stock market’s dividend aristocrats, increasing its dividend yield over 44 years – despite the cyclical nature of the steel industry.

More About Schnitzel Steel A

Schnitzer Steel (SCHN) is a global company that recycles metals. Founded in 1906, the company collects, processes, and recycles ferrous and nonferrous scrap metal for foundries worldwide.

The company provides low-cost auto parts to customers in Canada and the U.S. The company’s steel manufacturing plant transforms recycled scrap metal into steel products, such as wire rods, coiled bars, and reinforcing bars (rebars) for construction.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.