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Pair Trading After GameStop

Feb. 01, 2021 8:30 AM ETGameStop Corp. (GME)WBD, NFLX
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  • GameStop leaving permanent mark on pair trade strategies.
  • Who is benefitting.
  • Action for your portfolio.

I don't believe there is a need to go into the details of the recent market actions on GameStop GME , nor on the possible role of social media in price determination: I am sure you can read plenty of good press article on these topics.

What I want to analyse here is the long term implications of the GameStop saga for long/short hedge funds, and specifically for the ones specialised in pair trades. In addition I will try to go through the possible implications for many stocks typically involved in pair trading.

The classical pair trading investor is seeking alfa generation by identifying two stocks in the same industry, but with different expected return potential. Imagine, for the sake of it a BMW vs Tesla or a Netflix NFLX vs Discovery DISCA ,pair trade. The strategy, as we all know, goes through the building of a long position on the most appealing stock and of a short position on the less appealing one. The aim is to hedge the full beta, and gain for the hedge fund a return resulting from the delta performance of the two stocks. Ok nothing new here.

Now, after the GameStop saga, pair strategies are becoming very risk. Indeed no matter how much you know the industry, how much time you investigate the details of the two companies involved in the pair trade, how much you analyse the strategy of both, you run a risk, which is impossible to quantify: is your less appealing stock going to be the subject of an irrational buy wave, motivated by the desire of defeating and cornering the 'bad HF guys'? Are you going to be cornered and short squeezed on your short leg of the trade? 

Given the unlimited potential loss of a short position, the unforeseeable new risk posed by 'social media trading' the typical pair trade strategy is going to become much less appealing to rational professional players. 

Here what should you expect, in order:

- Reduction of long positions. The covering of existing shorts on GameStop like stocks is causing significant losses for many hedge funds, their reaction is to reduce their gross exposure. So they need to liquidate long positions to make up for exploding margin requirements. It's already happening: the most held stocks on the long leg of hedge funds, were already experiencing a significant price correction in the last few trading days. 

- General reduction of short positions. Hedge funds are also closing short positions for the combined reason a) to have back the liquidity posted in their margin; b) fear of going through a disaster similar to one experienced in GameStop. This has a positive price effect on stocks involved in the short leg of pair trades. On this respect see, for example, the price movement of Discovery , a typical short leg on the Netflix long, up 30%+ since 1st jan.

- Change in strategy. Hedge funds will reduce their gross exposure by cutting pair trades or they might decide to switch from single stocks pair trade to long single stock vs short index (so avoiding single stock shorts).

Consequences for your portfolio:

Short term: I expect a relative outperformance of most of the stocks with a say 10 days or more short open interest vs the index and vs the most held stocks by hedge funds ( both list are widely available, no need to copy them here).

Long term:  shorts on single stocks will decrease significantly, hence, for the market as a whole, liquidity and price accuracy will suffer. It will become even more difficult and risky to extract alfa with pair strategies.

In the short term: stay away from pair trades, be careful on indexes and, if anything, buy oversold good companies (if you find one, maybe Discovery?). But I don't really like to trade on social media 'vibrations', so, in the long term, even tougher time for us alfa seekers! 

Analyst's Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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