Paired trades are sound strategies

Some traders like paired trades, where positions are taken at the same time in two correlated, or inversely correlated instruments. Compared to a single trade, the returns from a paired trade can be about the same, while the risks are lower for paired trades. However, the trader needs to juggle market lots for equal exposures.

There may be potential paired trades opening up in the petroleum and gas public sector undertakings (PSUs). There is some speculative buying visible in the public sector oil marketing companies (OMCs). Crude oil prices have dropped, reducing the pressure on Bharat Petroleum Corp Ltd (BPCL) and Hindustan Petroleum Corp Ltd (HPCL). There are rumours diesel prices could be raised again, which would make OMCs more attractive as their under-recoveries would reduce further.

On the other hand, lower crude oil and gas prices are, in theory, bad for producers such as Oil and Natural Gas Corp (ONGC) and Oil India Ltd. But the upstream companies also have to share the subsidy burden for under-recoveries by HPCL and BPCL. So, although ONGC, for instance, loses profitability if international crude oil prices reduce, its expenses are also reduced since it need not subsidise OMCs to the same extent.

If crude oil prices continue to fall, we could have a situation where the share prices of HPCL and BPCL gain, while ONGC's share price drops. The gap between the share prices of OMCs and the price of ONGC should widen. A trade of short ONGC and long HPCL, or short ONGC and long BPCL could be profitable.

Another possible paired trade is opening up in the currency market. The outcome of the Greek elections may have staved off an immediate chaos in the Euro zone. This could result in hardening of the euro.

For the past several months, a long USDINR has been a profitable position since the US dollar has strengthened steadily. Now, there is a case for a long EURINR position since the euro should strengthen at least temporarily. Apart from the unhedged long EURINR position, there should also be a relatively low-risk paired trade of long EURINR and short USDINR.

This paired trade will work if the euro strengthens against the US dollar as it should, on a relief rally.

The point is that it aims to exploit a change in the relative values of the US dollar and the euro. Both currencies may strengthen against the rupee, but the euro will strengthen more. Hence, the gap between the rupee-denominated US dollar value (say 56) and the rupee-denominated euro value will grow.

However, while the risk in the paired trade is less than the risk in an unhedged single currency futures trade, managing the risk to the paired trade is trickier. Both positions change in value and mechanical stop losses cannot be set. The trader must constantly monitor the gap and set a mental stop-loss to cut off losses.

The author is a technical and equity analyst