Finding stocks to pair trade
When it comes to pair trading it's always important to have logical, fundamental reasons for choosing the stocks that make up a pair trade. Doing cointegration and stationarity tests across hundreds of stocks will reveal many potential pair trading candidates but this opens you up to what's known as 'multiple comparisons bias'. What this means is that by randomly looking at hundreds of possible stocks to pair trade, you will inevitably uncover stocks that indicate that they are statistically suited to pair trading by pure chance and as a result of the large sample size.
A far better approach is to come up with a hypothesis with respect to potential stocks to pair trade and then test whether or not your hypothesis is correct. In other words, determine if there is a logical, fundamental reason why two stocks may be viable pair trading candidates and then perform the necessary statistical analysis to confirm or disprove your suspicions.
With the above in mind, a common method of finding potential pair trades is to look for ETF's that track similar characteristics. $EWC and $EWA for example track a basket of Canadian and Australian equities, with both countries being heavily commodity based.
As can be seen in the below screenshot, $EWC and $EWA have proved to be viable pair trading ETF's over the past 3 years.
Once two stocks have been shown to be viable for pair trading both from a logical, fundamental viewpoint and from a statistcal one, it comes time to look for entry and exit setups. The 60 days stress indicator for the $EWC / $EWA pair is currently at its most extreme since November last year. Add to this the fact that $EWC has had a large price drop over the last few days and is currently trading at what may potentially be a key price level.
For those new to pair trading, there are many concepts and metrics which require understanding. DiversifyPortfolio will be publishing educational articles over time that explain key concepts related to pair trading and how to apply those concepts to the tools provided to our members.
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DiversifyPortfolio does not make trading or investing recommendations. This article, as well as all the content and analysis tools on DiversifyPortfolio is published as a research and informational service. Please refer to our Disclaimer.