The Trade

So what is it that I do?  One of my main strategies is relative value spread trading.  Different people call it: “Pair Trading”, “Pairs Trading”, “Spread Trading”, “Statistical Arbitrage”, “Stat Arb” etc.  No matter what you call it, the basic premise is trading the relative value between two or more correlated instruments to profit from either the spread increasing or reducing in value.  One of the main benefits of the strategy is that you remain market neutral.  Read the links and they should give you an idea.

The most basic premise to enter a pair/spread/arb, a trader simply takes a long position in one security and a short position in another security in a balanced fashion.

As an example I’ve included a SPREAD chart of AAPL – (minus) MSFT because everyone is making a huge deal about this.

Note: Look closely at the formulas in the top left of the charts so see what the chart represents.

I constructed the chart to show the ratio of one share of AAPL to three shares of MSFT, because at the beginning of 2009 that ratio gave the trader roughly the same dollar value of stock on each side (zoom into the chart to see the formula).  If you went long one hundred shares of AAPL and short 300 shares of MSFT at the beginning of 2009 you would have profited handsomely.  You are technically market neutral because you have the same exposure to long stock as you do short stock.  So when the market went up, the AAPL shares outperformed the MSFT shares, and when the market went down you lost on the AAPL but made some money on the MSFT short.  Over time you made much more off the AAPL long, but in an alternate world the chart would still look the same provided that AAPL stayed relatively unchanged and MSFT shares lost a lot of value.  If you had the opinion that MSFT was a better company than AAPL and you went short AAPL and long MSFT you would have suffered large capital losses.

This is the simplest explanation that I can offer.  There are multiple strategies that involve lots of different legs, multiple longs and multiple shorts, options, etc.

This is probably not a trade I would take.  There is a laundry list of reasons why not to.  This is just an introduction to spreads using some household names.


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