What is pairs trading and how does it add value?

As an investor, I’m always looking for ways to generate stronger returns without taking on unnecessary risk. Markets don’t move in straight lines, and opportunities exist on both sides - in the companies that surprise on the upside and those that fall short of expectations. 

One way to implement this is using an Alpha Extension strategy, also known as a long/short extension. This approach is designed to amplify active returns by combining a traditional long-only portfolio with a short-selling overlay. 

At TenCap, we run a 150:50 strategy, which allows us to lift gross exposure to 200% while typically maintaining a net long exposure of 100%. This structure lets us overweight our highest-conviction long ideas, while shorting stocks we expect to underperform and using the proceeds to further back our long positions.

This style of investing gives us greater flexibility to express our views across both rising and falling markets. It means we can generate alpha from both sides of the ledger without increasing overall market exposure. 

In strong markets, it provides additional leverage to the upside, and in weaker conditions, it helps reduce downside exposure. Unlike traditional long/short strategies that often shine only when markets fall, our approach aims to add alpha across different market cycles while remaining style neutral.

Where Pairs Trading fits in

Pairs trading is a natural complement to an alpha extension strategy. It involves identifying two historically correlated stocks - often within the same sector - and taking opposing positions when their outlook and prices are expected to diverge. The goal is to profit from the relative movement between the two, assuming the spread will eventually revert to its historical mean.

Unlike directional trades, pairs trading is market-neutral, meaning it seeks to generate returns regardless of whether the broader market rises or falls. This makes it particularly valuable in volatile or uncertain environments or by allowing the portfolio manager to add alpha when the market is directionless, volatile or even falling. At its heart, it is focused on adding value through relative performance rather than absolute performance by attempting to reduce (often cancel out), shared factor risk. 

Pairs trading strips out common exposures, it therefore allows you to isolate stock-specific drivers such as earnings beats, management changes, valuation anomalies and to avoid unintended bets on macro factors or sector rotations. This leads to cleaner attribution of alpha - you know whether your trade worked because of your thesis on the stock, not because the market moved in your favour

There are numerous benefits that pairs trading brings to an alpha extension strategy:

1. Alpha amplification: Pairs trades target mispricing between stocks, enhancing return potential without increasing net exposure.
2. Risk control: By hedging sector and factor exposures, pairs trading helps reduce unintended portfolio risks.
3. Tactical agility: The strategy allows for quick responses to earnings surprises, sentiment shifts, or valuation dislocations that may not impact all stocks within a certain industry,  sector or investment cohort.
4. Diversified alpha sources: It adds a layer of relative value investing that complements directional long and short positions.

At Ten Cap, we can implement single stock pair trades or more complex forms where we may construct baskets of stocks for pair trade purposes. In addition, we run a proprietary hedging model whereby we group stocks into 5 broad categories – Natural Resources, Yield, Global Cyclical, Domestic Cyclicals and Growth – rather than using more narrowly defined classifications. 

By aligning companies this way, we can more effectively manage our stock, industry and macro exposures because it allows deeper stock subsets and for stocks which are in different sectors (due to the industry they operate in) to be paired against each other if they have similar stock characteristics. For instance, we include Tech and Healthcare within Growth, allowing us to pair stocks across two different sectors regardless of the industry they operate in.

Pairs trading in action

To illustrate the practical application and effectiveness of pairs trading within our alpha extension strategy, we highlight the following two pair trades:

Long: SEEK (ASX: SEK) / Short: Car Group (ASX: CAR)

At the start of the year, we initiated a long position in SEEK against a short in Cars Group. The rationale was twofold: 

1. A large valuation differential: CAR’s earnings multiple had shifted from the lowest in the classifieds group (REA, SEK, CAR) to the upper end following its US acquisition.
2. Earnings trajectory: While CAR remains a solid business, its share price reflected a string of positive developments, leaving little room for upside. Conversely, SEK was trading at trough earnings levels, with the market pricing in extreme pessimism. Signs of recovery in job market churn suggested SEK’s earnings outlook was improving. This asymmetry - CAR priced for perfection and SEK priced for distress - made the trade compelling. Since inception, the pair has delivered over 20%.

Long: Coles (ASX: COL) / Short: Woolworths (ASX: WOW)

Cultural shifts and management changes at Woolworths have weighed on performance, while Coles strengthened its market share. Over the past 12 months, Woolworths has ceded earnings momentum and market premium to Coles. This pair trade generated an impressive 30% return, underscoring the power of relative positioning.

Conclusion: Enhancing returns while controlling for risk:

Pairs trading enhances an Alpha Extension strategy by adding a layer of precision and control. It allows managers to isolate stock-specific opportunities while neutralising broader market and factor risks. By focusing on relative value rather than absolute direction, pairs trades help amplify alpha, improve portfolio diversification, and reduce exposure to macro-driven volatility. 

In essence, pairs trading transforms the Alpha Extension strategy from a directional long/short approach into a more refined, stock specific market-neutral engine for consistent outperformance - especially valuable in environments where dispersion is high and macro signals are noisy.