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Pairs reinforce long record of effective risk management

Excerpt from Australian Financial Review. 21 February 2008

The bear markets demand effective risk management, and one strategy involves a method once used exclusively by institutions - pairs trading.

Pairs trading was developed about 30 years ago and has been used by the world's largest financial institutions and hedge funds, to make good returns while reducing market risk by simultaneously taking a long and a short position on two different shares.

Unlike "normal" trading, where profit or loss is determined by the price movement of just one share, a pairs trader makes and loses money according to the relative performance of the two positions with the shares in the same market sector.

A pairs trader aims to be market­neutral, which means that long and short exposures are equal. If an external economic factor affects the

share price of both companies, the trader will make and lose the same amount on each leg of the trade, provided the price difference between the two remains the same.

A survey last year by training outfit HomeTrader revealed that a + majority of share traders were seeking "market-neutral" strategies to provide protection during major market corrections like those of last August and November, and this interest has increased during the current volatility.

Over the past two years, HomeTrader's research in strategies such as pairs trading, has resulted in what its executive director Jason Davis sees as heightened interest with "over 400 traders ready to give pairs trading a go for the very first time".

With the bears now dominating the markets, HomeTrader has completed a series of training courses which explains the benefits of pairs trading and warns of the pitfalls.

“Whilst pairs trading is a smart trading strategy it is important to remember that every trader is still exposed to the risk of company­specific events," Davis says.

In a global analysis, the ASX has noted that all manner of investors from large endowments such as Harvard University to retail clients use the strategy because it is regarded as less risky than an outright purchase or sale.

"Implementation varies but the idea is the same - to buy the undervalued pair and sell the overvalued pair," the ASX advises on its website. "A good starting point is to chart two related stocks that you have an interest in. This will show you how much they have diverged in the past and how quickly they came back together."

The general idea is to pick two companies, generally in the same industry, in the expectation that the difference in price between the two will either contract or increase. It will not matter whether the overall stock market moves up or down. If the traders gets the relative change in the two shares right, the trade will make money.

The increased investor interest in pairs trading comes amid the rapid growth in the use of leverage, especially by less sophisticated market participants.

The leverage revolution began when futures became available to the retail punter, then options, warrants and more recently CFDs. The ability to amplify returns is an attractive draw card for traders, but as the bull market surged ahead many traders forgot that risk was not exempt from this amplifying effect.

"Traders are drawn to leveraged products like bees to honey; CFDs are the most recent example of this," Davis says. "Since their introduction in Australia in 2002, traders have consumed CFDs with an insatiable appetite."

The 11 consecutive days of market free fall in January spelled the end for some traders who had disregard even basic risk management by over-leveraging themselves in the market, Davis believes, noting that the record number of margin calls by CFD providers was evidence of the "frightening" position many traders found themselves in.