Pair trading is a relative value trading strategy where an investor seeks to profit from the relative change in one stock or asset relative to another stock. Pair trading is considered market-neutral as the direction of the ratio between two stocks is not predicated on the direction of the broader market indices.
Pair trading strategies are often developed by taking simultaneous long and short positions in different stocks to generate robust returns by finding relative value. Pair strategies generally focus on stocks, but investors can use other assets such as corporate bonds or government yields to find robust pairs. There are many methods that can be used to find stock pairs with a focus on companies which are in similar businesses and have highly correlated returns.
Developing a Pair Strategy
As mentioned earlier pair trading, is a market neutral strategy in which value exists because one stock price is cheap or rich relative to another stock price in a similar business. Pair trading avoids direct exposure to the broader market indices (the beta) and instead gives a ratio exposure. The relative value nature of pair trading eliminates the volatility associated with directional signal stock trading.
Two distinct styles of pair trading include mean reversion strategies and trending strategies. Each employs a number of techniques to generate a trading idea. Mean reversion strategies examine stocks with relatively high correlation coefficients and find historical levels when examining the ratio of one stock to another. Trend strategies generally focus on the fundamentals of two stocks and are more discretionary in natural.
Pair strategies seek to take advantage of highly correlated stocks which might experience a divergence in short term correlation. The correlation defines in logarithmic terms the relative relationship between variables. Two stocks in which the returns move in perfect tandem will likely have a correlation coefficient of 1 or in percent terms 100%. Two stocks that move in the opposite direction will have a correlation of -1. Investors can back test a time series to determine if the relative of two stocks will revert to the mean.
Bollinger band strategies on ratios are goods strategies to use to find a move from a moving average on a ratio that show robust historical results.
Risk management should be incorporated to insure a strong trading strategy. Investors should understand that a ratio between two stocks can continue to widen beyond historic means and should target a notional value stop loss based on the change in the stock ratio.
An investor should find two stocks that have similar business models. This could include stocks that are in the wholesale consumer business sector that have similar businesses such as Wall-mart and Costco. These two companies participate in a commoditized business which requires strong execution. There will be times especially over the medium term in which one stock outperforms, and investors can look for a rebound in the spread between the returns of the stock pair.
Executing Pair Trades
Investors can execute pair trades in using a number of financial products. The most common form is to simultaneously purchase a specific notional value of one stock, and short selling the same notions value in another stocks. To execute this type of trade an investor would need to have a margin account which will allow them to borrow a stock that in turn can be sold. Margin accounts will often provide leverage on stock purchases but leverage is less available for short sales.
Another type of pair trade is an option strategy in which an investors purchase call option on one stock and put option on another stocks. Investors who use options to pair trade should understand the leverage and risk associated with options.
A third type of strategy that can be employed to initiate risk on pair trades is pair options. This type of products offers pair trader’s options that speculate purely on the spread between two stocks. The dealers within this sector offer “above or below” option on a ratio between two stocks. The options can vary from long term monthly transactions on a pair option to short term hourly options on a stock pair. Pair options offer leverage, which can be significant.