Is Matched Pair Trading For You?

| October 22, 2010

When I started my working on Wall Street I was always learning new things. I worked closely with many different investors and saw various ways of making money. Not only did I learn about all the exciting security types – stocks, bonds, commodities, currencies, REITs, MLPs, ETFs…

But I also learned new ways to trade.

I met with long only funds… they only bought stocks they thought would go higher. I met with short investors who only sold stocks they thought would fall in value. I learned about traders focusing on turnarounds, vulture investors focusing on bankruptcy, deep value investors, growth investors, GARP investors, and even market neutral investors.

Toss in the 130/30 leveraged funds and my mind was swimming.

One trading technique really caught my attention… matched pair trading.

It sounds complicated, but it’s not. The idea of matched pair trading is so simple a 10 year old can understand it. And you can start using it right away to make more money in your own account..

Now like baking a chocolate cake, there are hundreds of recipes out there. The same is true with matched pair trading… everyone seems to have their own twist on the basic premise. Let me give you the basics and you can take it from there.

So what is matched pair trading?

Matched pair trading is when you always trade in pairs… When you find one stock you love (and think will go higher) you identify another stock you hate and think will go lower. The basis of the idea is these stocks are linked in some way.

Matched pair trading is often used by hedge funds. And the profits can be huge when you get the trade right.

Consider this. In a matched pair trade you buy one stock (money out) but you also short one stock (money in). Traders would call this capital neutral. It allows hedge funds to use the freed up capital in another trade. It’s a sneaky way to use leverage and further amplify gains.

But let’s not make this too complex.

Any trader can set up and execute a matched pair trade. You simply need the ability to buy a stock, and you need to be authorized to short a stock. Now setting up a trading account is no problem… a little money and a heartbeat is all that most brokers require.

Getting approval to short stocks is a bit more involved.

Your broker will make you jump through some hoops and sign additional forms. If you want to learn more contact your broker. Let’s get to the trade.

Let me give you an example of how this would work.

Do you remember the video store chain Blockbuster (BLOAQ)?

I remember renting VHS tapes from our local Blockbuster. The store was always packed. But they had the corner on video rentals. Eventually DVDs replaced VHS… and the company continued to grow.

Blockbuster generated billions of dollars in revenue. And of course their stock went through the roof!

Less than 8 years ago, blockbuster traded for over $14 a share.

That’s when rival upstart Netflix (NFLX) showed up. I don’t think this company needs an introduction, but just in case you don’t know… Netflix provides DVD rentals through the mail. For something like $15 a month, you can select a number of movies and they’ll send them to you. When you’re done watching one you ship it back… and they send the next one on your list.

The idea took off like a rocket ship, and so did the Netflix stock price.

The convenience of renting a video through the mail… not having to return it by a specific date or time, and avoiding the dreaded late fees all added to the popularity of Netflix.

If you were looking for a matched pair trade, it didn’t get any better. You buy the scrappy upstart who’s stealing market share… and you short the bricks and mortar dinosaur.

Just look at what happened a few years later.

BLOAQ vs. NFLX

Blockbuster (red line) fell from $14 a share to less than $0.04… That’s right, four cents a share. While Blockbuster fell, Netflix climbed from under $5 to over $170!

The profit potential on this trade is huge. And your percentage gain is mind numbing. Think about it… you’re long one stock (money out) and you’re short another (money in) so your capital outlay is tiny. Theoretically it could be zero! That means every dollar made would be an infinite return on your investment.

But it doesn’t quite work this way in the real world. You won’t have an infinite return, but the money made is nothing to sneeze at. Just a back of the envelope calculation shows $1,000 short Blockbuster and $1,000 long Netflix would have returned almost $34,000!

So when you find a company you absolutely love… or hate… take a few moments and look at the competitors. You might have an easy, and very profitable, matched pair trade on your hands!

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Category: Stocks

About the Author ()

The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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