Chapter 7-7 Pairs Trading

A pairs trading strategy is a market neutral strategy designed to enable traders to profit in virtually any market condition, regardless of uptrend, downtrend or sidewise (choppy) movement.  Introduced in early 1980′s, the strategy has only recently become popular among retail traders since the introduction of online trading gave the masses access to sophisticated trading systems.  Opportunities in pairs trading often only last for a very short period of time, and thus the quick response to market movements that can only be achieved by high degree of automation is required.

The first and most important step in pairs trading is identifying the pairs themselves.  Pairs are trading instruments (stocks, options, futures, currencies, bonds, etc.) that show high correlation; that is the price of one security moves in same direction of the other.  For stocks, pairs can be shares of two companies in the same (or related) industry.  For options, it can be options on highly related stocks.  For futures, it can be mini and full-size contracts or futures of related (same) industries.  Lastly, for Forex it can be currencies of countries having good trade relations.  Traders should use various fundamental and technical analysis tools to find these pairs; once pairs are identified the strategy is quite simple.

Pairs traders look for a divergence in the correlation between the shares that make up a pair.  When a divergence is noticed, traders take opposite positions in the instruments that make up the pair.  For stocks, currencies, and futures, the trader takes a long position in the underperforming instrument and a short position in the outperforming instrument.  For options, the trader writes a put option on underperforming stock and a call option on the outperforming stock.  In most cases, the cost of taking one position is offset by the revenue generated by the opposite position.  The trader makes a profit when the divergence is corrected and the instruments are brought back to the original (near original) correlation by market forces.

Pairs trading successfully demands good position sizing, excellent market timing, and strong decision-making skills.   Although the strategy has a relatively low level of downside risk, there is a scarcity of opportunities and the trader must be one of the first to make the trade in order to capitalize on the opportunity.  Statistical arbitrage, popularly called StatArb, is the broad scale application of the pairs trading strategy.  Strategies are designed to profit from pricing inefficiencies in the market by tracking down divergences in correlations.  Unlike pairs trading, however, StatArb includes downside risk.

In statistical arbitrage, traders construct portfolios consisting of a number of different stocks, which are carefully matched to reducing market risk and stock beta.  Stocks are carefully screened using fundamental and technical tools including industry analysis, beta, volume, growth, value, and performance history.  In most cases, the stocks in the portfolio are scored using mean-diversion principle and other mathematical models. The stocks which are underperforming receive high scores while and outperforming stocks receive low scores.  The strategy is to take long position in stocks with high scores and short positions in those with low scores.  In both pairs trading and statistical arbitrage continuous data mining, market and price analysis, and price matching are extremely important.  Additionally, large position sizing, low trading costs, and better trading platforms can offer better profits.

Traditionally, pairs traders have been divided into two schools of thought- technically focused and fundamentally focused.  Each of these styles has certain advantages over the other; however neither fully captures the scope of information available in the broad market.  In both cases, the investor is attempting to identify a pair of stocks that has diverged from its standard relationship and is highly likely to revert back to that mean relationship.  This market-neutral approach to trading has been gaining in popularity as both retail investors and professional portfolio managers seek to capture gains that avoid the volatility usually associated with the market.

The fundamental approach, generally favored by large institutions, is based on extensive company research aimed at determining a proper valuation for a given stock, similar to long term value investing.  Once this analysis is complete, a pairs trader makes a trade by buying the most undervalued stock and shorting the most overvalued stock in any given industry.  Over time, the fundamental values of the companies will be realized by broad market forces and the two stocks will converge to their initial valuations.  The technical approach, essentially a specialized version of StatArb, relies on technical indicators such as moving averages and various oscillating indicators to determine how to appropriately match equities for trading.  These factors are programmed into complex computer models that remove the human element from trade determination and execution.

 

While pairs trading most often refers to trading two stocks against one another, the recent insurgence of ETF volume has made it possible for pairs traders to match a stock against its sector or even an index as a whole.  Once the underlying fundamentals of pairs trading have been mastered, options may be used to synthetically create a pairs trade.  Pairs trading options requires significant knowledge and practice, but can offer flexibility unavailable in the equity/ETF market.  This is particularly the case when market conditions change abruptly and the trader wants to adjust the overall position appropriately.  As single stock futures gain popularity, futures spread traders have also begun to apply pairs trading techniques increasing both the liquidity and the accuracy of the trades.

 

Consider the following graphic that depicts the advantages and disadvantages of the various pairs trading vehicles:

 

 

Vehicle

Advantages

Disadvantages

Equities (incl. ETFs) – Simple- Stable- Most liquid

Capital intensive

Options – Allow for hedging use– Defined downside risk

Limited profit

Futures – Greater returns due to leverage- Additional markets provide diversification

Most volatile

Unlike many other strategies, pairs trading does not require extensive industry knowledge or advanced quantitative analysis skills.  Investors of all experience levels can successfully execute the strategy if they can learn to think outside the box.  If you consider a pair graphically, like an individual equity, the technical and fundamental factors that are in play should become more obvious.

Consider the charts of JP Morgan Chase (JPM) and the Financial Select Sector SPDR (XLF) over the same time period:

equities-content-image-7-7-1

Most observant investors will agree that the two securities have behaved similarly over the past 18 months simply by looking at these charts.  Both securities began the time period in a strong uptrend, consolidated for a short period, spiked up around May 2010, consolidated again, and have begun 2011 in another uptrend.  However, it is impossible to determine how closely these price movements follow one another simply by looking at these two graphs.  Neglecting further analysis, a trader might determine that these stocks are correlated to each other.

It is easy to misinterpret the results of this analysis and conclude that when the prices of the two securities crossed one another that these points would be appropriate entries or exits for the trade.  This logic is flawed because if the two stocks do not follow their historical relationship the trader has little recourse for how to manage the trade.  Furthermore, the trader has no basis to judge when the pairs trade has been a success or when it has failed and should be closed.

Investors should consider the pair from a market-neutral point of view to best extract useful information about the likely behavior of a pairs relationship.  This can be achieved by graphing the price ratio between the two stocks, in this case JPM:XLF, effectively creating a dollar-neutral perspective.

Consider the following chart graphing the JPM:XLF pairing over the same time frame as the individual components:

equities-content-image-7-7-2

This chart depicts the ratio between the two securities as a constantly changing entity.  To draw this chart the price of asset A is divided by the price of asset B.  In this example, this constitutes dividing the price of JPM by the value of XLF.   If you consider the price levels on the original two charts this is calculated as 44.89/16.41 which is equal to 2.74.    Similar to an individual equity, this relationship will have an opening value, closing value, maximum daily value, and minimum daily value that can be charted using candlesticks.  The greater the ratio is the further away the two securities are in value thus it can be concluded that on “up” days the two are growing apart (diverging) and on “down” days the two are coming together (converging).

Once the relationship between the two assets is depicted from this perspective you should begin to see that using market neutrality makes trading this pair a much more straightforward endeavor.  Ratio charts display the price relationship in a manner that moves within a defined range over the period of time under consideration.  This is useful for the trader because he or she can now forecast the likely direction that the pair will move as well as the extent to which the relationship between the two is likely to fluctuate.

It goes without saying that not every pair will produce a straightforward graphical representation as this one does, but this example does a wonderful job of illustrating how two securities interact with one another.

Revisiting the example of JPM/XLF reveals two important features of pairs trading- pairs trades should always be set up as dollar-neutral and technical analysis should be performed on the pair as a whole rather than on the component securities individually.  Although this may take some time to get used to, traders must get used to the idea of considering a dollar-neutral pair as a single trade rather than two individual trades in order to be a successful pairs trader.  This is because the vehicle being traded, represented in this case by the pair in the ratio chart, essentially becomes a single entity and therefore can be analyzed as such.

As you become more and more comfortable considering the relationship between two securities as opposed to two individual entities, the usefulness of technical analysis becomes much more straightforward.  You can now use tools that you are comfortable with and are knowledgeable about to analyze the likely future behavior of the pair similar to how you would analyze a single stock.  Technical indicators, including moving averages and various oscillators, can now be applied appropriately to the pair to help anticipate future fluctuations.

Although much of the focus thus far has been on technical analysis, fundamentals are every bit as important because pairs analysis often mask the effects of fundamental news.  When analyzing a single security, whether a stock, future, or currency, the effects of major news events are fairly obvious when looking at the chart.  Examples of this are a great earnings report that causes a sharp spike or a CEO scandal creating a sharp drop-off.  Unfortunately, these blips in the radar are often invisible when analyzing a pairs trade through ratio charts.  Consequently, fundamental analysis is a critical component in pairs trading, although it need not be as vigorous as the use of fundamental analysis in value investing.  Due diligence should be performed to ensure that pairs are behaving in a correlated matter due to a real historic relationship and not just recent activity that is generating a false signal.  An example of this would be if two stocks report earnings on the same day, one company does great, the other terrible, and the ratio between the two looks like an incredible entry for one day.  Do not be fooled into thinking that these securities are going to revert to the mean, in actuality they will likely continue going in these newly established directions and thus a pairs trade would be an instant loser.  A quick overview of daily earnings reports would avoid this conundrum entirely.

Thus, as the previous example indicates, technical and fundamental analysis is blended together in pairs trading much more than in other strategies.  It is imperative that you become familiar with both means of analysis as well as the instruments primary used with each in order to properly implement pairs trades.  Furthermore, adhere to a reasonable reward-to-risk ratio when participating in such a trade as it is possible for even the more sound correlations to unexpectedly increase divergence.  Therefore, as always, have a solid plan in place and stick to it.  Remember, practicing sensible money management techniques is always the best move.

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