Defined in Investopedia, a pairs trade is matching a long position with a short position of two different stocks in the same sector.
In this environment where we see whole sectors going down, there are always good stocks taken down with the bad. This happened with technology in the early part of this decade and it’s happening now with financials.
With the invention of ETFs, I think pairs trading could work well here. Here’s the way it works, I’m cautious on the banks and financials in general but I think certain stocks are getting beaten up unjustly. For example, we’re seeing Goldman Sachs going down with Lehman Brothers. I can buy Goldman Sachs and short Lehman Brothers and try to make the spread essentially. Another way to look at it is you can afford to buy the good ones but hedge yourself with shorting the bad ones.
I also like shorting the bad sector using an ETF but going long the individual stocks in that group. Are you worried about steel? You can short SLX (steel ETF) and go long U.S. Steel (X). X is near a high while the steel sector is flattened out recently.
It’s not a complicated strategy but it can be used in the short-term or long-term. You can use it in the short-run if you bought a good stock but worry about it going down further because the sector is taking you down. You cover the short position when you think the sector is doing going down.
But, in the long-term owning Goldman Sachs while shorting Bear Stearns wouldn’t have been a bad move either.
Use this sell off to identify the best companies in the world on sale.
