By hedged I mean pairs, not options or other derivitives. I'm not always 100% neutral, sometimes I'll favor longs or shorts, but generally not more than about 60/40. I started my account with $15k.
I've been to pairstrading.com and looked over the idea. ya, i have a finance degree and understand the concept (at least i think i do) of hedging, but i'm not sure what the advantage is with pairs trading. I mean, if you have a slight long or short bias why wouldn't you just position yourself as such in one stock. yes i realize now you're not hedged, but in a way you are because of decreasing the size of your "net" position. During those times when you are hedged closer to 50/50 "net zero" and you are pairs trading (similar correlation, right?) then don't your positions offset the gain/loss? I'm assuming the response would be that you are long the stock you feel might be slightly "undervalued or underperforming or out of line" with the other stock which you would be short. I may be completely missing something here. Is this the idea? When one moves up faster relative to the other, then if you're long take some off the table and if you're short add to it? Do you always maintain a short in one and long in the other and just take profit when it moves in your favor and add to the position when it moves against it? Thank you.
To me, although there are theoretical calculations that say you have a hedge when trading pairs, it doesn't necessarily mean that the risks are less. Its true that with hedges pairs trade may approach larges risks less percent of the time, however when a pairs trade does happen to hit the points where things turn upside down, they do so in a hurry. With both legs going in a losing direction, your risk is at least twice as great as with a straight non-paired trade. Ive traded pairs for a while and to me its not more risky than a completely long or short position, but it does offer a lot of flexibility and diversity. Pairs can have important info that links two instruments, such as an implied relationship like terms of a merger deal, companies in related industries and the like. Or pairs can have some demonstrated technical relationship between two entities. For a trader, if I can quantify a relationship between lets say two stocks, by using a graph for example, this also serves as a "relationship." So pairs gives the flexibility of giving a trader the power to create what I would call "synthetic" instruments to trade. Try taking some stocks that are not fundamentally related, graph their spread, and see if you can identify any technical patterns that you have seen before in stocks. I enjoy the flexibility of pairs trading. I don't agree however that pairs trading offers any less risk than other forms of trading. Even considering the market neutrality factor (which is mainly a selling point for investors), pairs trades and pairs traders that are successfull honor all the risk management fundamentals of successfull traders everywhere. My point is, that the discipline required by both is the same. A non disciplined approach to pairs trading is just as costly as doing the same thing in straight direcitonal positions. Solid discipline is rewarded in the same measure.