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Dipping Your Toes in the Water

Trying to identify the bottom of a bear market is next to impossible. Luckily for you, when you implement a pairs trading strategy, you don't have to know exactly where the bottom is before you start putting your money back into stocks.

Pairs Trading Can Reduce Your Risk

Pairs trading—buying one stock and simultaneously selling a similar stock—is a great way to get back into the market without taking on too much risk up front. [To learn more about pairs trading, check out our article and video on Pairs Trading in the Market.]

For instance, if you see a stock—Home Depot (NYSE: HD) for example—that you believe is going to be moving up in the near term but you are still nervous about the performance of the overall market, you can find another similar stock—like Lowes (NYSE: LOW)—to sell simultaneously.

If the market goes up, you should make money on your Home Depot trade, which is a great thing. However, if the market goes down and you lose money on your Home Depot trade, you should also make money on your short Lowes trade—which should offset most or all of your losses.

NEXT: Learn about the 10 Steps to Buying Stocks in a Bear Market.

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Don Davis  - Mr   |2009-01-17 01:41:04 How does one manage stop losses with pairs trades?

swadehansen  - Stop Losses   |2009-01-19 02:37:35 With pairs trades, the best thing to do for a stop loss is to set a mental stop loss that identifies a dollar amount you are willing to lose on the trade. You can't really set a price point for either stock at which you want to get out because that won't give you enough information. You have to look at what both stocks are doing together before you can make an informed decision about when to get out. Here's an example: Let's say you want to risk $5 per share (which is a pairing of both shares in this case). If you are down $8 on one of your shares, you may be tempted to get out, but you have to look at the other share first. If you are up $10 on that share, then you are net positive $2 ($10 - $8 = $2). Obviously, you wouldn't want to get out of your trade. However, if you are only up $3 on your other share, you are net negative $5 ($3 - $8 = -$5). In this case, you would want to exit your trade.

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