Wednesday, September 10, 2008

ETF Investing strategy: Pairs Trading

ETF products are expanding. We have ETF groups with stock markets indexes, sectors or industries. All these exchange traded funds are even flavoured internationally. In addition to equity ETFs you can invest your money into exchange funds underlying commodities, currencies, bonds or other fixed income.

This explosive growth brings possibility to play different investment strategies with ETF. Today I'd like to focus on Pairs Trading. Investment strategy based on trading pairs is telling us:

"Being long the best stock and short the worst stock in the same industry."

How we can use ETF to eliminate risk for this strategy. Let's imagine that the investor wishes to limit risk being wrong from either long or short pick. In this case we can go long with outstanding stock and short an index; ETF. Or the other way around to go short with the worst stock and long with related index.

It is always difficult to find 2 stocks for pairs trading. By ETF substitution we can lower the risk that improbable event will trigger unwanted move.

Nice example is Intel (INTC) vs. AMD (AMD). Going long with INTC and short with AMD would benefit by 80% for the last 2 years. But now someone can be afraid that AMD is really oversold and any good news will definetely bounce shares. But still long term prospect seems to be better for Intel. In this case you still stay long with Intel and short Semiconductor ETF (SMH) or (IGW).


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