Risk Isolation Using Market Neutral Strategy

Abstract

Ultimately, trading is about risk versus reward. We would love to make 100% returns, but how much are we willing to risk to do so? One advantage that institutions and large portfolio traders historically held was their ability to trade in more dynamic ways. With the proliferation of the internet and online trading, smaller investors are progressively able to execute such strategies to their own benefit so that they can manage risk versus reward in a similar fashion to institutions. One of the strategies performed exclusively by institutions is the ability to trade spread or pair positions. This technique has been around since the ability to short sale stocks and involves going long one financial instrument and short a correlated instrument to minimize or isolate risk. This strategy has been done with every financial instrument before, but we are primarily going to focus on pairing two equities together. This paper presents how a common investor can isolate risk and produce more consistent returns using pair trading.

TOPICS: Portfolio construction, equity portfolio management, VAR and use of alternative risk measures of trading risk