It’s difficult to predict the direction of short-to-intermediate market moves. That’s why some traders gravitate toward market-neutral strategies, which can offer potential profits regardless of the market direction. One popular market-neutral strategy is pairs trading.
In pairs trading, you identify two stocks with price movements that are highly correlated—or tend to move in tandem. When the correlation appears temporarily weakened, you simultaneously take a long position in one stock and a short position in the other stock. If the correlation reverts back to the observed mean (average value), you’ve made a profit. Let’s look at how you execute this strategy in detail.
Choose the pair
Stocks in the same industry tend to have stronger correlations than those in the unrelated industries.
A cursory look at a chart can help you narrow down pairs that should work. For example, Figure 1 shows QRS (the red line) overlaid against XYZ (black line). While these companies are in the same industry, you can see that their stocks don’t always move in the same direction.
Figure 1. (Source, StreetSmart Edge®)
Now take a look at Figure 2. It shows BBB (red line) overlaid against JJJ (black line). The correlation is much stronger.
Figure 2. (Source, StreetSmart Edge®)
While these charts can help you narrow down a successful pairing, the next step is to find the actual numerical correlation between the two stocks.
Find the correlation
Correlation is a term from regression analysis that determines 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— meaning, one variable moves up, the other moves down. A value of 0 means there is no statistical correlation, and a value of 1 means a perfect positive correlation. In our Figure 2 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 consider trading the pair.
Calculate the price ratio
The next step is to calculate the price ratio of the pair, which is 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.
Figure 3. (Source, StreetSmart Edge®)
In Figure 4, Schwab’s Price Relative Study can calculate and plot this ratio automatically.
Figure 4. (Source, StreetSmart Edge®)
Check if the ratio is mean reverting
Once we have the price ratio plotted, we determine if the ratio is mean reverting (moving to the average value). 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, which is at the midpoint. When the ratio rises above .98 or so, it tends to drop, and when it falls to around .84, it tends to rise. The trading strategy for this pair is to sell short JJJ, and buy an equal dollar amount of BBB when the ratio is at .98. Another strategy is to buy JJJ and sell short an equal dollar amount of BBB when the ratio is at around .84.
Some traders will perform historical modeling—that is, a doing a deeper analysis of the price ratio range by evaluating years of price data. Using this method, they can predict an increase to the probability of a profitable trade by identifying how many standard deviations the ratio needs to move away from the mean.
A final consideration when choosing the pair is that both stocks must be easily shortable.
Advantages of pairs trading
An advantage of pairs trading is the ability to potentially make profits regardless of the way the market moves. For example, if the stock 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 initiated 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 (change in a data measure) declines in account equity than 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 initiated, 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 market reactions to external events or conditions. Also, the trader has potentially unlimited risks because of the short stock position.
Another 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 initiated 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 for those who want a market-neutral strategy. Just as with any strategy, I 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.