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ETF Pairs Trading 101

|Includes: F, General Motors Company (GM), IBUY, XRT

Pairs trading has been around since the 1980s. The trading strategy involves holding positions in two highly correlated securities, one long and one short, forming a market neutral position. Being market neutral allows traders to profit under any market conditions, uptrend, downtrend, or sideways. But the reverse is also true, it also allows traders to lose money under any market conditions.

Stock Pairs

Traditionally, pairs trading has been based on statistical arbitrage. When there is a price divergence between a pair of highly correlated stocks, then long/short positions are entered in the opposite direction of the divergence, with the assumption that mean reversion will occur. Ford Motor Company (NYSE:F) and General Motors Company (NYSE:GM) are a popular trading pair. The stock charts and example pairs trades are shown below.

The problem with this strategy is that it is based on statistics and a shift in fundamentals could cause the trade to get out of control.

Question: Would you consider going long F / short GM now (Feb. 2017)? Please provide an answer and rationale in the comment section below.

ETF Pairs

ETFs are less risky than stocks, but are also less volatile, and therefore mean-reversion doesn't provide much opportunity for profit. Instead, trading trends provides much greater potential for profits.

Macro Trends

A macro trend has a long life, a result of many forces in your community that you cannot manipulate. Like a river, you go with the current or exhaust yourself fighting it.

(Quote Clint Burdett Strategic Consulting)

An example macro trend is the massive growth in online retail at the expense of brick and mortar.

(Source: amplifyetfs.com)

I expect that this trend will continue for the next several years and can be exploited by buying the Amplify Online Retail ETF ( IBUY) and shorting the SPDR S&P Retail ETF (NYSEARCA:XRT) as described in Online Shopping Thrashes Brick And Mortar.

There are other macro trends that can be exploited using ETFs, such as the two European issues detailed in 2 Pairs Trades You Can Take To The Bank.

Market Cycles

Market cycles include the business or economic cycle and yearly seasonal patterns. The main problem with market cycles is that they don't always transpire as expected. Unlike long term trends, establishing good entry and exit points are critical for profitability.

The business cycle is often referred to by economists and investors alike. But I don't know of anyone who can identify where we actually are in the cycle, except after-the-fact. For this reason, I usually avoid trades related to the business cycle, unless is it part of a clear macro trend.

There are plenty of possibilities for seasonal trading strategies. Many patterns are identified on timingthemarkets.com and I hope to write about some seasonal pairs trades in future Seeking Alpha articles.

Long / Short Position Ratio

In general, the long and short positions should be equal dollar value at the time the position is initiated. The exception occurs when the beta for the two ETFs are vastly different, in which case the ratio of the two positions should account for the difference in beta. The objective is to create a market neutral position, which has a beta of 0. If ETF 'A' has a beta of 1 and ETF 'B' has a beta of 2, then the ratio of A to B should be 2:1.

Short-Selling

There are some considerations that inexperienced investors need to be aware of when it comes to short-selling stocks and ETFs. The first is that you cannot short-sell securities in a tax-sheltered account. You need to open a margin account for this purpose.

A position that is being shorted can be liquidated from your account at any time by your broker without warning. Traders should be watching their account regularly. This is not a general occurrence, especially with popular securities, but it is something you should be aware of.

The third consideration is your choice of broker. Not all brokers are equal when it comes to shorting securities. Some brokers charge an exorbitant amount for the privilege of borrowing stocks. Interactive Brokers falls into this category. Other brokers don't charge anything. I use TD Waterhouse in Canada and they do not charge for borrowing securities for the purpose of short-selling. Before engaging in pairs trading, ask your broker what the fees are. You might find that pairs trading is not practical without switching brokers.