An Investor's Toolbox: The Pair Trade

When intending to bet one security will outperform another, investors often will enter into a pair trade to take advantage of the differences in performance.

A pair trade is constructed when someone buys one security and shorts another with the intent to profit off of the spread between the future price performance of both securities.

Pair trades can be used for a variety of strategies. Take Company X and Company Y for example. If an investor believes Company X will increase in share price more (in percentage terms) than Company Y, the investor can profit from the difference by buying Company X and shorting Company Y in equal amounts.

The investor can also profit as both stocks go down in price, as long as Company X goes down less than Company Y.

Related Link: Terms Of The Trade: Earnings Per Share

Calculating Returns

The investor would make the difference of Company X's (the long) percent change minus Company Y's percent change (the short).

Pair trades can be used as a strategy to become market neutral, since perfect pair trade investors have the same amount of money short as they do long. Many hedge funds use pair trades to protect themselves from large moves in the market.

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