Finding profits in Pairs Trading Strategy is relatively simple through simple and comparatively low-risk trades. The pair’s trading strategy is market neutral. In other words, the direction of the overall market does not determine profit or loss.
The aim is to weigh side by side two strongly correlated trading instruments (one long and the other short) when the pair’s price ratio deviates by a number of standard deviations “x”, the “x” value is optimized using historical data. When the pair returns to the average trend, one or both operations will benefit.
What is a Pairs Trading Strategy?
Pairs trading is an arbitration trading method in which there is a statistical difference between two stocks with similar characteristics that are highly integrated or strongly correlated. This is possible for statistical reasons, where the spread of the two stocks returns to the average value over time. In the early days, the pairs trading strategy was popular because of the possibility of arbitrage. As many investors, including hedge funds, took advantage of these opportunities through pairs trading strategy, profitability began to decline. To overcome these shortcomings, a lot of research has been done to improve the pairs trading strategy.
The pair trading strategy mechanism is as follows: First, identify a few stocks that show a similar trend. Second, compute the spread of these stocks using regression analysis like ordinary least squares (OLS), total least squares (TLS), and error correction models (ECM). Finally, if the spread is out of bounds, investors will go long for undervalued stocks and open short positions on overvalued stocks. Then, when the spread returns to the average, the investor closes the portfolio with positions different from the open portfolio. In this case, the investor is benefiting from arbitration under this strategy.
However, there is a risk when the spread does not return to the average. In such a scenario, the investor is at high risk because the portfolio cannot be closed. By setting a stop-loss limit, investors can hedge their risk.
Market Researchers (Quants)
Quants are the Wall Street name for market researchers who use quantitative analysis to develop profitable trading strategies. Simply put, Quants combine the price relationship and mathematical relationship between companies or trading instruments to predict profitable trading opportunities. In the 1980s, a group of quants working at Morgan Stanley sought gold through a strategy called pairs trading. Institutional investors and trading desks of large investment banks have used the technology since then, and many have made good returns with this strategy.
Since sharing profitable trading strategies with the general public doesn’t favor investment bankers and fund managers, the pairs trading strategy remained a profit secret until the advent of the Internet. Online trading provided access to real-time financial information and gave beginners access to all kinds of investment strategies. Before long, pairs trading started to attract individual investors and small traders looking to protect their risk to the wider market.
Many researchers have used various statistical methods to improve the efficiency and productivity of the pairs trading strategy. In particular, their focus is on using spreads as a trading signal. The study of the acquired stocks was centered on reducing the sum of squares of the deviation between the two stocks and implementing the pairs trading strategy if the difference between the pairs is twice the standard deviation of the spread. They tested the profitability of pair trades using data from normal US stock prices from 1962 to 2002. This study used a joint consolidation strategy to protect the pairs trading strategy from significant losses. They utilized the OLS method to generate spread and set various conditions that were converted into trading instruments. Based on these models, they achieved a pairs trading strategy with minimal profit shielded from the risk of loss. The results showed about 11% of annual income for that period.
Examples of Pairs Trading Strategy in The Stock Market
Traders can utilize fundamental or technical data to build pairs trading strategies. Although our example here is of a technical nature, some traders use P/E or other underlying factors to measure correlation and divergence.
The primary step in the creation of pairs trading is to find two closely linked stocks. This usually means that companies operate in the same industry or sub-sector, but not always. For instance, stock tracking indices such as QQQQ (Nasdaq 100) or SPY (S&P 500) can provide good pairs-trading strategy opportunities. Two indices that are commonly traded together are the S&P 500 and the Dow Jones Utility Average. This simple price chart of the two indices below is an illustration of the correlation.
In this example, let’s look at two closely related companies: GM and Ford. Their stock tends to move together as both are American automakers.
Below is a weekly price chart for Ford and GM (calculated by dividing Ford’s share price by GM’s share price). This price ratio is sometimes referred to as “relative performance. This is not the same thing as the relative strength index. The central white line represents the average price ratio over the past two years. The yellow and red lines represent 1 and 2 standard deviations of the mean ratio.
In the chart above, you can determine the potential profit when the price ratio reaches the first or second deviation. When these lucrative diversions happen, you can enter a long position in the stock that is underperforming and enter a short position in the stock that is over-performing. It is cheaper to trade in pairs, as the profit from the short position will help cover the cost of the long position.
The position size of the pair should match the dollar value, not the number of shares. So, a 5% move in one stock becomes equivalent to a 5% move in the other. As with any investment, there is a risk that your position may run in the red, so it is important to determine the optimal Stop Loss point before executing the pair trading strategy.
Using The Pairs Trading Strategy in The Futures Market
Pairs Trading Strategy applies not only to stocks, but also to currencies, commodities, and options. In the futures market, “small” contracts (small contracts representing a fraction of the value of a full-scale contract) allow small investors to trade futures.
Pairs trading in the futures market may include arbitration between the futures contract and the currency position of the index. When the futures contract is ahead of the cash position, a trader may try to profit by selling the futures position and buying the monitored stock index, which is expected to converge at some point. Frequently, the fluctuations between an index or commodity and its futures contract are so great that profits are passed only to the fastest traders, who often use computers to automatically perform a real-time staggering amount of trade.
Pairs Trading in The Options Market
Options traders use calls and put to hedge their risk and take advantage of volatility (or lack of volatility). A call is the author’s promise to sell a stock at a fixed price at some point in the future. A put option is a seller’s promise to buy a stock at a fixed price at some point in the future. Using the pairs trading strategy in the options market can involve writing a call for securities that outperforms their pairs (other closely correlated securities) and matches the position by creating a sell option on the pair (the securities that are underperforming). When the two base positions return to their average values, the option becomes useless, allowing traders to profit from one or both positions.
The market fluctuations and their impacts on trades can make weak traders easily exist in the market. It sometimes equally leaves the veteran traders and smartest predictors confounded. Fortunately, investors and traders can take advantage of any market situation by using market-neutral strategies such as the pairs trading strategy. The advantage of pair trading is its simplicity. The relationship between a long position and a short position in two adjacent securities serves as a stabilizer for the portfolio held during turbulent conditions in the overall market. We wish that you can leverage this tool to become more profitable in your trades. Good luck!