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Pair Up Your ETFs For Enhanced Trading Profits

When investors hear the term "pairs trading," most probably think of foreign currency trading where pairs trading is the most commonly used tactic. In forex trading, a pair is simply two currencies combined in the same trade such as the Euro/U.S. Dollar (EUR/USD). Well forex trading isn't every investor's cup of tea, but that doesn't mean pairs trading cannot be applied to other asset classes. In fact, pairs trading is an excellent strategy to employ with stocks and ETFs.

Pairs trading with ETFs is a fairly easy strategy for traders and investors alike to implement and it is useful not only in short-term time frames, but also for longer-term investors as well. Essentially what an investor does in an ETF-based pairs trade is identify a fund that looks poised to outperform the market over a certain period of time and then proceed to hedge that bet by being short a sector or index fund that looks like it will be a laggard.

For example, an investor that sees that the broader market is starting to embrace risk, might look at higher beta names, or those stocks that move even more than the market. A good choice in this scenario might be a commodities-related ETF. If commodities are in vogue, identifying the sectors that are hurt by high commodities prices gives us a great hedge.

All of this sounds great, but picking individual stocks for pair trades can be tricky, so let's take a look at another way, perhaps a better way, to implement the pairs trading strategy with.

Thank Goodness For ETFs

As we have discussed countless times in previous work, the evolution of exchange traded funds (ETFs) has been nothing short of impressive. This asset class offers investors all the diversification of a traditional mutual fund with the potential for greater returns because ETFs are more liquid and trade like stocks. Equity-based ETF encompass every industry under the sun and that makes them the ideal asset class with which to pair trade.

As we noted earlier, it can be a tricky endeavor to identify the right stocks with which to implement a pairs trade. You may know that you want to implement a pairs trade by going long an oil stock and shorting an airline stock, but with hundreds of offerings between the two sectors, how can you be sure that you pick the two best options to pairs trade with? Unfortunately, there really is no way of knowing that your selections will prove profitable and that's what makes using ETFs for pairs trading such a good idea.

Obviously, being long oil and short airlines is a great pairs trade when oil prices are soaring as they have been. The chart comparing the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) and the Guggenheim Airline ETF (NYSE: FAA) shows as much. In this example, since there is no inverse airline ETF and being directly short FAA is risky, purchasing some in-the-money puts on FAA would be the way to play this ETF from the bearish side.

XOP- FAA Performance Chart

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Plenty Of Other Examples

There are plenty of other examples where ETF pairs trading can be a winning strategy. If you could go back in time to May 1 knowing that the market would do exactly the same think it did this May, I bet you'd rush to buy a consumer staples ETF and a short S&P 500 ETF (which you would only hold for a week or two). I could go on, but the bottom line is ETFs are great for pairs trading and this strategy can be employed by rookie and veteran investors alike.


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Stocks: XOP, FAA