Trading Long Short made simple

Long Short, Pair Trading, Relative Value Strategy, are all synonyms. They are basically a market-neutral trading strategy that involves matching a long position with a short position in two highly cointegrated and correlated stocks. The idea is to profit from the relative performance of the two stocks; buying the cheaper stock (long) and selling the expensive stock (short). This approach is designed to minimize risk from broad market movements, focusing instead on the strength of one stock relative to another.

Identifying a pair of stocks involves finding two securities that are historically related and move in sync with each other. Typically, these are stocks from the same industry or related sectors (e.g., Coca-Cola vs Pepsi), which respond similarly to market conditions. To identify an appropriate pair, traders examine historical price data to find stocks where the subtraction of each return series outputs a stationary series, indicating a stable relationship over time. Additionally, you can use forward looking data such as the IV to size your trades.

When engaging in long short strategies, it's important to recognize the risks involved. These strategies, which involve buying a stock while simultaneously shorting a stock, can be highly sensitive to the relative move between both stocks. Shorting a stock can lead to theoretically unlimited losses. Avoid shorting small caps or low float stocks, as they can be highly volatile and difficult to Borrow. Small biotech stocks are particularly risky due to their high volatility, often driven by FDA approval processes and M&A potential. Implied volatility, a forward-looking metric, can also effectively signal this risk, helping investors gauge potential price fluctuations.

Sizing and scaling a pair trading strategy effectively requires careful consideration of several factors. Beta, which measures a stock's volatility relative to the market, and IV can help you gauge expectations based on the options market while taking into consideration historical data and thus, allowing you to size your positions accordingly and ensuring that each side of the pair trade contributes proportionately to the overall risk and potential return of the strategy. This approach not only hedges against market volatility but also aligns the strategy to the unique characteristics of the paired assets.