Traders have multiple tools at their disposal to analyze price movements and trends to make profits; however, the challenging part of the job is to look for instant or short-term changes in the market. One strategy that has helped traders prevent losing too much of their investment is pair trading.
Some call it a failproof strategy because the stocks are not affected much by the broad market conditions. After pairs trading with two highly correlated stocks, you long the overachiever and short the underperformer to neutralize the impact when they diverge. This is a fundamental concept behind a pair’s trade.
What is Pairs Trading?
Pairs trading is a market-neutral strategy to identify and pair two stocks, generally from the same sector or industry, which show an identical positive movement. When the movement disrupts, the two stocks deviate from the path causing a spread that becomes a trade opportunity.
In pairs trading, you buy the outperforming stock and sell the other when this trade opportunity arises to balance profit and loss. The direction of the broad market does not affect the loss or gain of the strategy of the trades. Traders tend to lose less in pairs trading when they thoroughly understand and employ the pairs trading strategies.
Origin of Pairs Trade
Despite being a market-neutral strategy, pairs trading is still a less popular strategy among individual traders.
It all started in the mid-1980s when many computer scientists, physicists, and mathematicians of Morgan Stanley were assigned to experiment with arbitrage.
(If you do not know what arbitrage is, it is the technique to make a profit by identifying the mispricing in the market and taking advantage of it by buying and selling the same thing in two different markets.)
In 1987, they traded their BlackBox successfully, making a $50 million profit, but the next two years went downhill, and the group disintegrated in 1989.
However, the results did not go unrecognized by top firms and performers who experimented with pairs trading to learn more about it and gain returns. Three economists at Yale Business School analyzed the data from 1967 to 1997 and revealed that the traders averaged a +12% return.
Until the advent of the internet, this strategy has been a secret of pro-investment bankers and mutual fund managers who have used it ever since its discovery.
Today, pairs trading works wonders for individual traders, hedge fund traders, and institutional traders as a market-neutral investment strategy.
It’s essential to reiterate the consistent reliance on technical analysis, market data, market direction, trading signal, statistical methods, and proven trading strategies for successful trades.
Understanding Pairs Trading Strategy
Pairs trading relies heavily on price movement, price ratios, historical trends, data, and trade statistics. The key to gaining profits with a pair trading strategy is selecting trading pairs with a good arbitrage opportunity and determining entry and exit points.
The Process Behind this Market Neutral Strategy
The pairs trading process can roughly be divided into six steps:
- Have a selection criteria
- Select stocks to pair
- Conduct research
- Execute trade
- Manage and monitor
- Close the trade
As mentioned earlier, the two stocks are usually paired from the same sector or industry.
For instance, HDFC and ICICI (banking sector), Microsoft and Google (tech domain), or Tesla and Tata motors (automobile industry).
You can even go for a pairs trade with the same companies like Bajaj Finserve and Bajaj Finance (holding and subsidiary companies). Trading pairs from unrelated sectors is also possible; however, it tends to form a weaker correlation than the former ones.
We choose the same sector for a pairs trade because the companies of one industry will face the same changes and situations in a particular case and show similar movements. For example, if the stock of HDFC increases, the prices of the stocks of other banks like Bank of Baroda, Axis, or ICICI will also increase.
First, find the domain in which you want to invest using a pairs trade. There are hundreds and thousands of pairs trades possible in each domain, considering the number of stocks available. You cannot randomly select two pairs. Mathematical and statistical analysis will be your friends on the journey.
Correlation is identifying the degree to which two stocks relate to each other. It is the number that defines the relationship between a couple of stocks.
The coefficient for correlation, denoted by ρ, can range from -1 to +1, where -1 refers to a negative correlation, and +1 refers to a perfect positive correlation. 0 means there is no relation between the two stocks.
A positive correlation means that when one stock rises by 10%, the other increases by 10%. Similarly, if one stock decreases by 5%, the other shows the same movement.
That is a +1 correlation — a perfect match. A negative correlation is when one stock increases by 20%, and the other decreases by the same proportion.
This correlation is given by Correlation(X,Y) = ρ = COV(X,Y) / SD(X).SD(Y)
Where COV (X, Y) is the covariance between X & Y, and SD (X) and SD(Y) are the standard deviations of the respective variables.
You can even use a tool for feasibility tests like Quantsapp to determine the correlation between several stocks. A good pair will have a coefficient value equal to or above 0.85.
This is a good pairs trade strategy, but making trading decisions based on just correlation can give you inaccurate results because you cannot determine when the prices of the two stocks would mean-revert.
The next step is to find opportunities. The spread is the opportunity — whenever the two stocks diverge, the opportunity arises for trading.
You buy the underperforming stock and sell the overachieving one. The next challenge is how many stocks should you sell?
This is where most traders prefer the method of cointegration. This method or a statistical property allows traders to check whether the combination is stationary or not using a linear equation:
Spread = log(a) – nlog(b)
Where ‘a’ is the price of stock A, and ‘b’ is the price of stock B.
For buying every stock of A, you have to sell n stocks of B.
When the equation above is stationary, the spread = 0, then a and b are cointegrated. Any deviation from 0 indicates a statistical abnormality or simply an opportunity for pairs trading for traders.
Even though it is unaffected by market changes, traders must be vigilant of the unexpected news release that can affect the pair and be prepared to change their course.
For instance, if the expected 2-week profit is attained within the first week, the trader has two options. They can either close the trade to avoid uncertainty or initiate a trailing stop-loss level to lock in some portion of the profit.
Advantages and Disadvantages
A pairs trading strategy is a flexible strategy independent of market time and conditions. It is an excellent investment strategy for short-term traders to add to the portfolio as they can trade more in short time frames (30-minute chart).
But it is not a holy grail and is entirely risk-free. Since it is based on probabilities, the trader can incur a huge loss if the divergence lasts longer.
Traders, therefore, are suggested to set a risk limit where two stocks move out of sync to avoid unwanted outcomes. Also, prioritizing technical analysis for a pairs trade is crucial.
One of the challenging parts of the pairs trading strategies is closing the trade unless you are a disciplined trader with predefined buy and sell rules.
Sometimes it is difficult to close a trade that is losing money with hopes to gain profits; however, the results are always larger losses or reduced profits.
Example of Pair Trading
Now let’s take an example to make it clear.
Let’s say we found two stocks with a positive correlation of 0.95. The correlation seems lucrative considering our criteria to select stocks are 85% or above.
We will monitor their movement and wait for the divergence to occur. We rediscovered them at a correlation of 0.65. This is the trade opportunity, and we will short or sell the overachieving stocks and long or buy the underperforming stock.
This revenue from selling overachievers will neutralize the cost of buying the underperformers, making the trade inexpensive. Over time, the stocks will converge, and we will get an opportunity to make a profit.
The Key Takeaways
The market is full of ups and downs for traders who want to gain stability in these ruthless tides of waves. Market-neutral strategies like pairs trading act like a life jacket to keep them afloat.
Despite the changing waves, traders can manage to stick around and save themselves from drowning in losses.
The pairs trading strategy is easy to test and experiment with. It is a fool-proof strategy where the risk is minimal if you understand it thoroughly, research well, monitor closely, and are disciplined.