Stock Price Hedge Using a Pairs Order
From FXPedia
A strategy of combining off-setting orders to create a stock price hedge is a commonly-used method of investing in the stock market during uncertain or volatile times. It is typically employed when an investor feels that a certain company will out-perform most other firms operating in the same sector.
The objective of the stock price hedge is to buy (go long) a stock that you feel will increase in value, while shorting (selling stock you do not currently own) an equal amount in one or more stocks in the same industry. This is referred to as a pairs order and is designed to “cover” your long position – an uncovered order is euphemistically called a “naked” order.
The theory behind a pairs order lies with the belief that the strongest company in a troubled sector will likely see a greater increase in the stock price, while struggling firms are likely to see a reduction in share prices. Therefore, you should hold a long position in the company expected to out-perform and short an equal amount of the weaker firms as a means to hedge the risk of investing in an uncertain market.
In a short sell, you are essentially “borrowing” – in exchange for a transaction fee – fees from your broker who is holding the shares on behalf of another client. You may sell the shares you have borrowed (i.e. sell short) but you must be prepared to replace the shares when required. In order to replace the shares, you will be forced to pay current market prices which could be more or less than the price you received when you originally sold the shares short.
If the share price goes down by the time you are required to replace them, you will earn a profit. On the other hand, if the price has increased, you will suffer a loss as it will cost you more to replace the shares than you received when you sold them. Therefore, you only want to short securities that you are “bearish” on and expect to lose value.
Short Sell Example
| January 1 | – Short 1000 shares of ABC (i.e. borrow shares from your broker) | |
| – Sell 1000 shares of ABC @ 10.00 = $10,000 | ||
| July 1 | – Delivery of 1000 shares of ABC due | |
| – Buy 1000 shares of ABC @ 9.00 = $9,000 |
In this scenario, you would realize a profit of $1,000 dollars as you earned $10,000 on the short sale and it only cost you $9,000 to purchase the replacement shares, leaving you with a profit.
| Note: | You can also construct a pairs order using a long put instead of a short sell to create the short side of the order. A long put is an options contract that you enter into with another party that gives you the right, but not the obligation, to sell a given amount of a security at a given price. In other words, it is up to you if you wish to force the counterparty to buy the security at the agreed-upon price when the contract is due. Note that in order to arrange this however, you must find a counterparty willing to accept that meet the objectives of your hedge. In order to attract takers, you may be forced to accept an arrangemetn that only partially meets your needs. |
No hedging strategy can provide complete protection but no matter which way prices go, you can at least minimize your losses with a well-designed pairs order. Of course, you may also reduce potential gains in this manner, but with careful thought, you should be able to construct an effective pairs order hedge. Consider the following example that illustrates a possible hedging opportunity:
- Investor A realizes there is currently a great deal of volatility in the automobile sector and the fortunes of manufacturers are very much aligned with the overall health of the economy. Individuals often delay buying new cars during an economic slowdown as is currently being experienced in the U.S. during the first half of 2008. Oil price increases also continue to drive up the cost of diesel and gasoline, and there is a growing demand among potential new car buyers in the U.S. particularly, to move away from SUVs and other large cars in favor of smaller, more fuel-efficient vehicles.
This was certainly the case during the recession and energy crisis in the early 70s and there are obvious parallels in 2008 as record oil prices occur on a seemingly daily basis. The effect this is having on gas prices combined with the slowing of the U.S. economy are steering new car purchasers to less expensive vehicles that provide better fuel economy.
After taking this information and the new buying trends into consideration, Investor A feels that smaller, more fuel efficient cars with reasonable sticker prices could do well even in the face of a possible recession looming in the U.S. Despite recent efforts to meet this new demand, the U.S. “Big Three” automakers are a couple of years behind much of the foreign competition so there could be a short-term opportunity for a company like Toyota for example to have a strong year.
Even though Investor A feels this assessment is credible, there is still concern that an economic slowdown could hurt the overall automobile industry so Investor A devises the following hedge strategy based on $50,000 of investment capital:
- 1. Go Long (Buy) 500 Toyota (TM) at current market price
- 2. Go Short (Sell) 1200 GM at current market price
- 3. Go Short (Sell) 3260 Ford (F) at current market price
The investor’s balance sheet will look like this:
LONG SHORT
500 TM@101.72 = 50,860 1200 GM@ 19.96 = 23,952
3260 F@ 7.98 = 23,014
OPENING POSITION
Long $50,860 (Short $49,966)
You can see that once the transactions are completed, Investor A will own just over $50,000 worth of Toyota stock and at the same time will have a liability of slightly under $50,000 represented by the shorting of GM and Ford stock. From a hedging standpoint, Investor A’s purchase of 500 shares of Toyota stock is now covered. Note that while Investor A purchased Toyota to profit from an increase in share price and shorted GM and Ford primarily as a market hedge, if either GM or Ford is worth less when the short positions are closed, Investor A also stands to gain on the short sells.
To see how the hedge works, assume that after one month, there has been little change in the three stock prices. Toyota has increased slightly to 101.94, Ford has remained essentially stagnant at 7.96, and GM has increased to 20.08. Investor A’s balance sheet now looks like this:
LONG SHORT
500 TM@101.72 = 50,860 1200 GM@ 19.96 = 23,952
3260 F@ 7.98 = 23,014
OPENING POSITION
Long $50,860 (Short $49,966)
After One Week
500 TM @ 101.94 = 50970 1200 GM @ 20.08 = 24096
3260 F @ 7.96 = 25950
Long $50,970 (Short $50,049)
Open $50,860 ($49,966)
Profit $110 ($83)
Total Profit $27
If Investor A were to close all three positions after one month, there would be a very small profit of only $27. On the long side of the ledger, a profit of $110 was realized, but the short side resulted in a loss of $83 which reduced the overall profit.
However, after six months, much has changed in the market. Gasoline now averages well over $4 a gallon nationwide in the U.S. and shows no real sign of slowing down. As well, the housing and constructions industries are still reeling from the subprime mortgage problems and pick-up truck sales are down 40% from the previous year. This is a greater hardship for Ford and GM than it is for Toyota as truck sales make up a greater proportion of the North American retailer’s sales; fully one quarter of Ford’s total sales in recent years can be attributed to its pickup truck line.
In addition to making further inroads into the North American market, Toyota also increases its sales in other regions as well and surpasses GM for the first time as the global sales leader. All this is reflected in the share prices – Toyota jumps to 106.73, GM falls to 19.02, and Ford continues to languish and dips below eight dollars a share. Investor A closes all three positions to take the profits and the final balance sheet for this pairs order looks like this:
LONG SHORT
500 TM@101.72 = 50,860 1200 GM@ 19.96 = 23,952
3260 F@ 7.98 = 23,014
OPENING POSITION
Long $50,860 (Short $49,966)
After Six Months
500 TM @ 106.73 = 53365 1200 GM @ 18.02 = 21624
3260 F @ 7.96 = 25950
Long $53,365 (Short $47,574)
Open $50,860 ($49,966)
Profit $2,505 $2,392
Total Profit $4,897
In this scenario, Investor A would realize a total profit of $4,897; $2,505 of which came from a profit in the Toyota stock, while $2,392 was realized by closing the short positions in GM and Ford.
But what if Toyota did not perform as expected and the share price actually fell to $96.75 after six months? This would represent a loss on the Toyota stock of $2,485. However, this would be almost completely offset by the shorting of GM and Ford resulting in a small overall loss of just $93.00.
In addition, if Toyota, which is considered by many analysts to be one of the best performing brands in the sector today, were to lose stock value, then it is likely that GM and Ford would lose an even greater percentage given their difficulties over the last few years. This is really the key point in a stock market pairs order hedge – you look for a firm that is poised to out-perform in an under-performing market segment and buy shares in this company. At the same time, you short firms that are struggling and expected to lose share value.
| Note: | The pairs order example included here while based loosely on recent events, is presented for informational purposes only. The opening market prices are accurate for the period that this article was written but projected prices are for illustrative purposes only and are not to be interpreted as any form of future value prediction or trading advice. |
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