June, 2015

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What is Pair Trading?

There are many ways to make money in stocks, one such technique is called pair trading. Pair trading has been used by institutional investors and major investment banks since its start in the 1980s.  Having the potential to achieve profits through nearly low-risk positions and from any market conditions, such as uptrend, downtrend, or even a sideways movement.

The pair trading technique is a market-neutral trading procedure, which matches a long and a short position in a pair of stocks that are in the same sector. So what is pair trading exactly the short definition is the purchasing of one stock while selling another that is in the same sector. There is however a bit more to it than just the buying and selling of stocks. Pair trading makes use of under-performing stocks, meaning a stock that is not selling as well as another.

The objective is to match two highly-correlated stocks, betting that the spread between the two will converge at some point. The discrepancy between two stocks may be cause by many things such as large buying and selling for a stock, temporary supply and demand, or even a reaction for some important news on a company.

Traders look at stocks in the same sector like General Motors (GM) and Ford (F) or Wal-Mart and Target, finding the two that are most correlated to each other in movement.  To make pairing easier the two should have something in common whether sector or asset.

Next they will confirm the correlation with charts determining if they do move together. Doing this can be done with a correlation coefficient. there are online tools that can be searched for that will yield a “correlation coefficient calculator” as well as Excel has a “CORREL” function that will help to perform the calculations needed, and still yet some platforms provide a technical indicator that helps with this as well.

Finally before they can be bought and sold a price ratio or (relative performance )chart must be created. This is a chart of both of the stocks plotted together, it measures the deviation from the mean or normal spread in the pair. Some have a technical indicator that will help to figure this out others can use a average and standard deviation formula in Excel.

Once this chart has been plotted then the traders will look at the deviations in the stocks when the ratio moves from the mean they will go long (buy) on the lagging or underpriced stock and short (sell) on the overpriced stock.  The money made from selling the overpriced stock can fund buying the underpriced stock.

There are many strategies in pairs trading such as Standard deviation, spread price, price ratio, and percentage divergence. Each of these have the same base for pairs trading were they differ is in the method used in determining the price ratio.

The real question is when to jump in, and when to exit for both profit and loss depending on the standard deviation excursions.