PAIR TRADE IDEA - LONG MTN, SHORT ANGLO

The concept of pair trading has been with us since 1980's and like all great trading strategies, there are many different opinions on how it is to be done correctly. The basic idea behind pair trading is that traders take advantage of temporary changes in the correlation between two shares. In other words, if two shares are usually tightly correlated - move in the same direction at the same time - then a trader would look for a temporary change in this correlation and attempt to capitalise off this difference.

These opportunities are often only available to those who are sharp enough to see them and fast enough to take advantage of them. Therefore I offer a different way of looking at pair trading; a somewhat longer term view that should allow you to be in a 'market neutral' position, while making a low risk profit and without having to be glued to your computer at all times.

The pair trade that I propose is long MTN (MTN Group Ltd) and short AGL (Anglo American PLC). When we look at these two shares it very quickly becomes evident that MTN has been outperforming AGL for the last few years. So much so that on a weekly chart (bellow), their correlation coefficient is -0.829; which makes them almost perfect opposites. 

MTN vs AGL: Relative Strength Comparison and Correlation Coefficient

What this negative correlation really means, is that if one share goes up, the other share comes down. As you can see from the chart above, this been the case for some time now.

Note that this pair was chosen because both of these companies have a sizable weighting in the index and at one stage used to 'lead' our market and mostly because of their almost perfect negative correlation. As it is now the overall market is making new highs on an almost daily basis, yet these two drift further apart. Therefore it stands to reason that this negative correlation between these two shares will be with us for some time yet to come.

Even if AGL breaks its down trend and starts to rally, MTN should continue to outperform it. As you will notice; in the times that AGL rallied - or was in a bearish correction phase - the correlation between the two turned positive, yet during the times -as is the case now - that AGL falls, the correlation is once again negative. In plain English, what this means is that when AGL increased in price so did MTN, but when AGL decreased in price MTN did not, in fact, when AGL decreased in price MTN's price just kept on climbing.

Therefore in my view; this is a low risk trade that should provide a decent return and add  stability to a portfolio.