This is the first in a series of articles on pair trading where we will start off with the basics and build on knowledge from each article as we make our way through this powerful trading strategy. (Part 2 can be found here).
Although pair trading can be fairly complex, the aim of this article series is to simplify the topic and ensure that by the end of it you will have the knowledge, strategies, setups and tools you need to add this historically profitable strategy to your arsenal.
Definition: What is pair trading?
Pair trading is a strategy that involves entering a long position in one stock and a short position in another stock with the aim of profiting from a reduction in the spread between the two. It is important to note that this strategy cannot simply be applied to any two stocks.
Based on the above definition, when pair trading you are looking for stocks which have a history of moving in tandem. In other words, if you were to calculate the spread between the two stock prices you would find that over time that spread hovers around an average.
There is a rigorous statistical and fundamental analysis required of any stocks you are considering for pair trading. Exactly what this involves will be discussed in a later article. For now, we're just going to cover the basics.
Hypothetical Spread
The below chart illustrates the concept of a stock pair which tends to move in tandem. If you calculate the spread between the two by subtracting the price of one stock from the other, the result will tend to hover around an average over time:
As you can see, the spread generally hovers around an average represented by the two yellow lines. There are 3 distinct times where the spread widened significantly before returning back to normal.
What is important to remember is that we are not interested in the actual prices of the two stocks. We are interested in the price difference between the two and how that difference changes over time. In other words, the spread.
In a nutshell, pair trading is all about identifying times where the spread widens like it did 3 times in the above chart, so that you can profit when it returns to normal.
The Process
Once you understand the basics of what pair trading is, the general process is fairly straight forward:
- Identify stocks which are viable pair trading candidates.
- Monitor the spread between the pair.
- When the spread widens to a level that has in the past proven to be an extreme level, you short the stronger stock and buy the weaker one.
- When the spread returns to normal, you close both trades. You profit as a result of the narrowing spread.
Each one of the above steps is a topic unto itself and as such will be discussed in detail in future articles in this series.
Pair Trading $WDC and $STX
$WDC and $STX is a statistically and fundamentally valid pair to trade. The below chart shows the price movement of these two stocks over the last 3 years.
As you can see, the two stocks tend to move together most of the time. However there are two distinct periods of time when they didn't move together as shown by the yellow circles.
The circles are where the opportunity lies. The key with pair trading is identifying the times where the spread widens like it did in the above example so that you can profit from the spread returning to normal.
How do you profit
Pair trading is known as a market neutral strategy because you are not relying solely on the direction of the stock movement to be profitable. Instead, you are trading the spread between two stocks and as such can be profitable in numerous different scenarios.
Lets say we enter a pair trade by shorting $WDC and buying $STX. Here are a few scenarios of how things could play out:
$WDC | $STX | Outcome |
---|---|---|
Goes down | Goes up | We profit on both sides of the trade. |
Goes down | Goes down |
We profit on $WDC and lose on $STX. In other words, the profits from one side of the trade are offsetting the losses on the other side. There is no need to close the trade, we simply wait to see if the first scenario still plays out. In fact, if $WDC goes down faster and to a larger extent than $STX, we still profit even though that was not our initial intention. |
Goes up | Goes up | This plays out in the same way as the above example, ie: keep the trade open. |
Goes up | Goes down | We close the trade for a loss at a predefined level. |
Out of all the possible outcomes, only outcome number 4 results in a clear loss. Outcome 1 is the ideal result. Outcome 2 and 3 simply mean that we continue holding the trade since there is still an opportunity to profit.
Benefits of Pair Trading
- Crash protection: Since we are long one stock and short another, if we experience a significant stock market crash we can remain calm and leave our trade open because the losses from one leg of the trade will be offset by the profits on the other.
- Market Neutrality: Pair trading does not rely solely on market direction. There are times that the stock market stays within a range for several months, sometimes years. Simply buying stock during that time will yield very little profit. Pair trading on the other hand does not rely on you being correct on market direction. The market can stay largely unchanged and yet you can continue profiting from multiple pair trades.
- Self funding: Pair trading can often be self funding to a large extent. This is because the sale of the short stock pays for the purchase of the long stock.
- Statistically sound: Pair trading involves rigorous statistical and fundamental analysis to identify viable pair trading candidates. As such, when a viable pair has been found it tends to be profitable for years to come. Pair trading (aka: Stat Arb) has long been a common strategy used in hedge funds and trading firms.
Final Thoughts
Pair trading can initially be a complex topic, but once the general principles are understood it makes for an excellent addition to most traders repertoire of strategies.
There is a lot of statistical analysis that goes into identifying viable pair trading candidates which will be discussed in future articles in this series.
Our pair trading tool performs all of the required statistical analysis for you on any pair of stocks, presenting the resulting charts and stats in an intuitive format. After identifying viable pair trading candidates, you can save them to your watch list which will automatically update all the relevant stats on a daily basis. You simply wait until an entry or exit signal occurs before taking action.
Click here for part 2 of this series.
For more articles on strategy, tips, education and stock market analysis - click here to subscribe to our free newsletter
Disclaimer
DiversifyPortfolio does not make trading or investing recommendations. This article, as well as all the content and analysis tools on DiversifyPortfolio are published as a research and informational service. Please refer to our Disclaimer.
Comments
Comments are closed.