What is pairs trading?
Pairs trading is a non-directional strategy that bets on the price movements between two instruments. The key here is relative movements between two set of prices.
Pairs trading is a sophisticated trading strategy because it requires skills that are slightly different to long-only investing. Statistical knowledge, quantitative backtesting, technical analysis or fundamentals are all needed to some extent to create and manage successful pairs trading. Knowledge about short-selling is also required.
How does pairs trading work?
For example, a pairs trade could entail buying an ‘undervalued’ stock and selling an ‘overvalued’ one. The premise is that the undervalued security will appreciate over time – and the overvalued one will fall. This reversionary price move could be independent to the general market direction. Hence the term ‘market neutral‘.
One appeal of the long-short strategy is that the returns are independent to that of market benchmarks, given that the strategy does not rely exclusively on buying benchmark members. Funds that employ pairs trade often boast of making money in all market conditions.
Pairs trading strategy
Pairs trading is of the favourite trading strategies used by professional traders. With the advent of fast trading terminals, you can also seek profits from pairs trading too.
Best time frame for pairs trading
A pairs trading strategy that holds instruments intraday will rely more on statistical analysis than fundamentals. A long-term (weeks to months) pairs trading strategy is inherently different to that of a short-term one in terms of signal generation, research, and positional sizing.
Choosing markets for pairs trading
There are many ways to capitalise on the pairs trading strategy. Some focused on large-cap stocks; some on mid-cap stocks. Some trade equity indices ETFs; some exclusively on futures. A novice trader may focus on similar stocks within a popular sector (say, mining, banking or house builders in the UK) or between large indices (e.g. FTSE 100 vs FTSE 250). Larger stocks, such as FTSE 100 members, have better liquidity.
Here are our tips to help you find the best currency pairs to trade with.
Filtering pairs trading candidates
This requires pre-determined filters to extract viable candidates from noisy datasets. This is dependent on the skills of the traders. Is the trader much more comfortable with statistics, fundamentals or technical analysis? What is the trader’s edge? The strategy’s time frame is critical. Also, will the filter be done solely with computers? Once a pool of trade candidates is determined, the next step is to narrow down the specific trades to buy and sell.
Weighted volume when trading pairs
How much to trade on each leg, ie the amount to buy and sell? This is dependent on the trader’s goal. He may choose share-equal (100 shares to buy and short), dollar-equal ($1000 on buy and short), beta-neutral (long beta must match short beta), etc etc. A very volatile stock may inject more volatility into a relative trade if both legs are dollar-equal.
Pairs trading risks and costs
For each leg of the pairs trade, a stop loss level may be required. This means finding out where a trader would close the trade if it goes sour. A trader would also need to find out the costs of short an instrument due to dividends, and whether the stock is hard to short due to limited free float, corporate action, or regulatory embargo.
Executing a pairs trade
Some brokers have pairs trading features that allows customers to execute both legs quickly.
Managing pairs trade risk
Sometimes, the easy part is to initiate a trade. The harder part is knowing what to do afterwards. To manage a trade, a trader will need answers to these scenarios, ie, when:
- Both legs (long and short) are instantly profitable.
- One leg is profitable and the other in losses
- Both legs in losses suddenly
- A ‘short squeeze’ happens
Exiting pair trade positions
Once a trade is entered, there must be a plan to get out. Sometimes, the stoploss will do that for the trader. If not, a trade will need to monitor the trade continuously to see if the trade’s potential is still there. Sometimes, after a duration, the trade may be abandoned because it is not working out.
Pairs trading paper trading
Before committing real capital into a trade, it is better to take some time to backtest the strategy on paper. This is to iron all programming mistakes, bad data, determining ideal parameters, or just to ‘get a feel’ for the strategy. Can you live with the drawdown? What is the appropriate capital to execute the trade? etc
Lastly, I present a highly simplistic pairs trade example below.
Pairs Trade Example – Relative Ratio
For example, using a computer program a trader finds two correlated stocks that are diverging and wishes to bet on that divergence extending further. The long side is Standard Chartered and the short side is Barclays (see below).
Their current relative ratio is about 4.05. The trader expects a relative breakout to, say, 4.5. The stop loss is set at 3.75. This approach is very simple and is based on relative ratios alone.
For other examples, read Douglas Ehrman‘s Handbook of Pairs Trading.