When it comes to Risk Management, Options is the first instrument that comes to my mind. However, we would steer the attention towards Futures for a change today. Futures, or Forwards, actually (ones that are not traded on exchange) has always been used as a primary tool for risk mitigation.
I remember many forward selling their fruits produce to save themselves from the uncertainty raised by the upcoming season. However, we are not talking about that. We are talking about systematic risk mitigation.
Every Stock faces 2 Kinds of Risks
Systematic Risk: Risk posed by factors affecting country or sector as a whole (policy decisions, interest rates, geo-political risks).
Unsystematic Risk: Company-specific risks (risks like result miss, fire at plant, etc.)
We will talk about mitigating Systematic Risk. With Futures, it is very easy. Imagine there is Interest Rate Hike. This hurts the Financial Institutions. To remove this risk we can create a Pair of Buy & Sell positions in Futures.
Buy a Financial Institution Future +
Sell another Financial Institution Future
Factors positive for both or negative for both will have no impact on your Profit/Loss because they will get neutralized. Pairs Trading or Long-Short is a trading technique aimed at removing systematic risks popularized in 1990s in the world of Financial Derivatives.
Utility: This comes in handy in market situations like now. We have run by over 2000 points from recent lows of Jun 2022. These are times when one wants to Buy for Outperformance and Not Bargain Hunting. This is because everything has run up, just that some stocks have not run enough.
Plus, there is a risk that in search of this outperformance if there is a pullback, we may get trapped at the top.
Here this Systematic Risk Removal Strategy of Pairs Trading will be helpful.
If we Rise, the Outperformer will help in making money as it will Rise Faster. If we Fall, the Outperformer will Fall less again making us money.
The only risk is that if our call on Out performance is wrong. Well, that is the tiny risk we will have to take.
How to take Systematic Risk Removal a.k.a. Pairs Trade?
Easiest way is to concentrate on the stock that we want to Buy (In current context). Now, find the stock2 that closely behaves like the stock that we want to Buy. Lot of applications show comparative price performance these days. See the behaviour in last one year.
We are looking for
1. Highs and Lows are around the same period
2. Our Stock is lagging the performance of the stock2
Once confirmed, we can take a trade by Buying our Stock Future and Selling Stock2 Future. Keep a Stop Loss and Target of our Stock.
As soon as our stock Outperforms and Rises more or Falls less than Stock2, we make out money. In the process if we reach our Stock’s stop loss level then exit both the positions.
This is the crudest Pairs Trading technique. Of course, there are sophisticated quant models that track correlation of many sets of 2 stocks to give you best matched pair and gives the indication when to execute the Pairs Trade.
Logics behind these are generally proprietary however, they are up for grabs as well. The crude method may not be as effective, but it does the job of Systematic Risk Removal.
Finally, no matter what triggers the Pair but at the top instead of leaving opportunity due to high risk of Pull Back its better to use this Systematic Risk Removal Technique and continue trading Outperformance.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
