Predicting the direction of short to intermediate moves in the market is notoriously difficult. That’s why some traders gravitate toward more market-neutral strategies that can offer potential profits no matter which way the market moves. One of the more popular of these strategies is pairs trading.
Simply put, pairs trading involves finding two stocks whose price movements have been highly correlated, and then, when the correlation is perceived to have temporarily weakened, taking a long position in one and a simultaneous short position in the other. Profit is made if the correlation reverts back to the observed mean.
Choosing the pair
The first step in choosing the pair is to find two stocks that have historically demonstrated a strong degree of correlation in price movement. As a starting point, many traders will look for stocks in the same sector or even better, in the same industry group. Stocks in unrelated industries tend to have weaker correlations than those in the same industry.
A cursory look at a chart can often narrow down which pairs might or might not work. For example, Figure 1 shows QRS, the red line, overlaid against XYZ, the black line. While these companies are in the same industry, they obviously don’t always move in the same direction.
Figure 1. (Source, StreetSmart Edge®)
Now take a look at Figure 2. It shows BBB, the red line overlaid against JJJ, the black line. The correlation is clearly much stronger.
Figure 2. (Source, StreetSmart Edge®)
While looking at charts can help narrow down what might or might not work as a pair, the next step is to find the actual numerical correlation between the two stocks. Correlation is a term from regression analysis that seeks to see how closely a dependent and independent variable are related. The correlation coefficient is a number ranging from -1 to 1. A value of -1 means that two variables have a perfect negative correlation—one variable moves up, the other moves down. A value of 0 means there is no statistical correlational and a value of 1 means a perfect positive correlation. In our present example, over the last year, the JJJ/BBB pair had a correlation coefficient of .94 while the coefficient for the XYZ/QRS pair was only .25. Many traders want the coefficient to be .80 or higher before they would consider trading the pair.
The next step is to calculate what is called the price ratio of the pair. This is simply the price of Stock A divided by Stock B. Looking at Figure 3, we see that on this particular day JJJ was trading 91.22 while BBB was at 100.90 for a ratio of .90 rounded to two decimal places.
Figure 3. (Source, StreetSmart Edge®)
Schwab’s Price Relative Study can calculate and plot this ratio automatically (Figure 4).
Figure 4. (Source, StreetSmart Edge®)
Once we have the price ratio plotted, we look to see if the ratio is mean reverting. In Figure 4 this seems to be the case. The ratio has ranged from around .98 to around .84; the average of those two numbers is around .91, the midpoint of the range. When the ratio rises to above around .98 it tends to drop, and when it falls to around .84 it tends to rise. The trading strategy for this pair would be to sell short JJJ and buy an equal dollar amount of BBB when the ratio is at .98, or to buy JJJ and sell short an equal dollar amount of BBB when the ratio is at around .84.
Some traders will add more rigor to this technique by performing historical modeling. For example, they might download years of price data and do a deeper analysis of the range of the price ratio, seeking to discover how many standard deviations away from the mean the ratio needs to move to increase the probability of a profitable trade.
A final consideration when choosing the pair is that both stocks must be easily shortable.
Advantages of pairs trading
A major advantage of pairs trading is the ability to potentially make profits no matter which way the market moves. For example, if the market or the energy sector suffers a major decline, both Chevron and Exxon will most likely drop as well. If a trader is short one and long the other, the overall position is basically hedged. If the trade was put on when the price ratio was at an extreme and the price ratio then reverts to the mean, the trader can still profit.
Another advantage of pairs trading is that it tends to have smaller peak to trough declines in account equity then a net long or net short strategy.
Risks and disadvantages of pairs trading
The greatest risk with pairs trading is that when the trade is put on to take advantage of a weak correlation, there is no guarantee that the correlation will ever revert to the mean. This could be due to numerous factors, ranging from company-specific events to different reactions to external events or conditions. Also, the trader has potentially unlimited risks because of the short stock position.
Another obvious disadvantage is the higher level of commissions paid to implement the strategy. Since two stocks are involved in each trade, the total commissions are twice as high as a single stock strategy and can add up quickly over time.
There are also several execution risks associated with the strategy. To remain market neutral, both the long and short positions need to be put on simultaneously. Partial fills on one side or the other, or the inability to find shares to short, will disrupt the market neutral posture. Also, since the strategy seeks to exploit small changes in price, unfavorable fill prices—which can occur especially when stocks have wide bid-ask spreads—can dramatically affect profitability.
Pairs trading is a popular trading approach that appeals to many, especially to those who like the idea of having a more market-neutral strategy. Just as with any strategyI suggest that the trader have a trading plan with predefined entry and exit rules and have the discipline to follow them no matter what the market does.