The Long Stock/Short S&P Pair Trade

How To Minimize ‘Directional’ Risk, By Entering ‘Long’ The Undervalued Stock, And Simultaneously  ‘Shorting’ The S&P 500 Index – By Shiraz Lakhi.

There are two ways of trading stocks – either ‘single-directional’ (long-only, or short-only) speculative positions, which anticipates a selected stock moving in a particular direction along with the rest of the market, or a ‘comparative’ position, which anticipates a selected stock ‘outperforming’ the general market as whole (such as the S&P 500 index).  The latter, provides an advanced, market-neutral method of trading, which wagers on the stock doing ‘better’ than the S&P index, irrespective of whether the particular stock moves up, down, or sideways…

For the investor who wants to advance beyond the conventional, single-directional speculative (‘long-only’ or ‘short only’ positions) trade, and more critically, protect his/her position against the broader market directional risk (corrections, crashes, prolonged negativity), the long stock/short S&P pair trade provides resolve. The strategy involves taking a ‘long’ position in a stock the trader believes will increase in value, while taking a simultaneous ‘short’ position in the the S&P 500 index ETF (symbol: SPY)…

More popularly coined pairs trading, this particular strategy (entering long the stock and shorting the S&P) wagers on the stock ‘outperforming’ the S&P index. Put simply, the investor is not concerned about whether the selected stock will move up or down, but how it will do ‘relative’ to the overall market (S&P). By entering a long position in stock X (preferably one which exhibits robust fundamentals, such as a high free-cash-flow yield, amongst additional undervalue metrics) and simultaneously entering a short position in the S&P index, in exactly the same dollar value (in other words, if you enter long $30,000 XYZ stock, you would short $30,000 SPY), investors can establish a ‘dollar-neutral’ market-hedged position.

Effectively, no matter which way the overall market moves, whether it corrects, crashes or rallies, direction is of no relevance. In a pairs trade, the single point of focus is purely whether stock X will outperform the S&P. If both the stock and the S&P fall, as long as the stock declines less (in percentage terms) than the S&P, the trade results in a profit. If both the stock and the S&P rise, as long as the stock rallies more than the S&P, the trade results in a profit. Only if the stock ‘underperforms’ relative to the S&P does the trade result in a loss. The objective is, over time, the fundamentally superior stock will tend to outperform the market (S&P index).

Wishing you every success in your trading… and good spirit…

Shiraz Lakhi – Independent Investor/Entrepreneur