The Secret To Finding Profit In Pairs Trading

February 28 2011| Filed Under ETNs, Forwards, Futures, Options "Quants" is Wall Street's name for market researchers who use quantitative analysis to develop profitable trading strategies. In short, a quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to divine profitable trading opportunities. During the 1980s, a group of quants working for Morgan Stanley struck gold with a strategy called the pairs trade. Institutional investors and proprietary trading desks at major investment banks have been using the technique ever since, and many have made a tidy profit with the strategy. Tutorial:Guide to Stock Picking Strategies It is rarely in the best interest of investment bankers and mutual fund managers to share profitable trading strategies with the public, so the pairs trade remained a secret of the pros (and a few deft individuals) until the advent of the internet. Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn't take long for the pairs trade to attract individual investors and smalltime traders looking to hedge their risk exposure to the movements of the broader market. What Is Pairs Trading? Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss. The goal is to match two trading vehicles that are highly correlated, trading one long and the other short when the pair's price ratio diverges "x" number of standard deviations - "x" is optimized using historical data. If the pair reverts to its mean trend, a profit is made on one or both of the positions. An Example Using Stocks Traders can use either fundamental or technical data to construct a pairs trading style. Our example here is technical in nature, but some traders use a P/E ratio or other fundamental factors to measurecorrelation and divergence. The first step in designing a pairs trade is finding two stocks that are highly correlated.

Usually that means that the businesses are in the same industry or sub-sector, but not always. For instance, index tracking stocks like the QQQQ (Nasdaq 100) or the SPY (S&P 500) can offer excellent pairs trading opportunities. Two indices that generally trade together are the S&P 500 and the Dow Jones Utilities Average. This simple price plot of the two indices demonstrates their correlation:

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For our example, we will look at two businesses that are highly correlated: GM and Ford. Since both are American auto manufacturers, their stocks tend to move together. Below is a weekly chart of the price ratio between Ford and GM (calculated by dividing Ford's stock price by GM's stock price). This price ratio is sometimes called "relative performance" (not to be confused with the relative strength index, something completely different). The center white line represents the mean price ratio over the past two years. The yellow and red lines represent one and two standard deviations from the mean ratio, respectively. In the chart below, the potential for profit can be identified when the price ratio hits its first or second deviation. When these profitable divergences occur it is time to take a long position in the underperformer and a short position in the overachiever. The revenue from the short sale can help cover the cost of the long position, making the pairs trade inexpensive to put on. Position size of the pair should be matched by dollar value rather than number of shares; this way a 5% move in one equals a 5% move in the other. As with

all investments, there is a risk that the trades could move into the red, so it is important to determine optimized stop-loss points before implementing the pairs trade.

An Example Using Futures Contracts The pairs trading strategy works not only with stocks but also with currencies, commodities and evenoptions. In the futures market, "mini" contracts - smallersized contracts that represent a fraction of the value of the full-size position - enable smaller investors to trade in futures. A pairs trade in the futures market might involve an arbitrage between the futures contract and the cash position of a given index. When the futures contract gets ahead of the cash position, a trader might try to profit by shorting the future and going long in the index tracking stock, expecting them to come together at some point. Often the moves between an index or commodity and its futures contract are so tight that profits are left only for the fastest of traders - often using computers to automatically execute enormous positions at the blink of an eye. An Example Using Options Option traders use calls and puts to hedge risks and exploit volatility (or the lack thereof). A call is a commitment by the writer to buy shares of a stock at a given price sometime in the future. A put is a commitment by the writer to sell shares at a given price sometime in the future. A pairs trade in the options market might involve writing a call for a security that is outperforming its pair (another highly correlated security), and matching the position by writing a put for the pair (the underperforming security). As the two underlying positions

revert to their mean again, the options become worthless allowing the trader to pocket the proceeds from one or both of the positions. Evidence of Profitability In June of 1998, Yale School of Management released a paper written by Even G. Gatev, William Goetzmann, and K. Geert Rouwenhorst who attempted to prove that pairs trading is profitable. Using data from 1967 to 1997, the trio found that over a six-month trading period, the pairs trade averaged a 12% return. To distinguish profitable results from plain luck, their test included conservative estimates of transaction costs and randomly selected pairs. You can find the full 34-page documenthere. Those interested in the pairs trading technique can find more information and instruction in Ganapathy Vidyamurthy's book Pairs Trading: Quantitative Methods and Analysis, which you can findhere. The Bottom Line The broad market is full of ups and downs that force out weak players and confound even the smartest prognosticators. Fortunately, using market-neutral strategies like the pairs trade, investors and traders can find profits in all market conditions. The beauty of the pairs trade is its simplicity. The long/short relationship of two correlated securities acts as a ballast for a portfolio caught in the choppy waters of the overall market. Good luck with your hunt for profit in pairs trading, and here's to your success in the markets.

Pairs trade
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This article may be too technical for most readers to understand. Please help improve this article to make it understandable to non-experts, without removing the technical details. The talk page may contain suggestions. (November 2012)

Example of pair trade graphical representation The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as astatistical arbitrage and convergence trading strategy.[1] The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglias quantitative group at Morgan Stanley in the 1980s.[2][3] The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the "spread" between the two would eventually converge.[4] The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on. Pairs trading strategy demands good position sizing, market timing, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity. A notable pairs trader was hedge fund Long-Term Capital Management.[5]

Contents

1 A simplified example 2 Examples of potentially correlated pairs 3 Model-based pairs trading 4 Market neutrality 5 Algorithmic pairs trading 6 Drift and risk management 7 References 8 External links

[edit] A simplified example

Pepsi (PEP) and Coca Cola (KO) are different companies that create a similar product, soda pop. Historically, the two companies have shared similar dips and highs, depending on the soda pop market. If the price of Coca Cola were to go up a significant amount while Pepsi stayed the same, a pairs trader would buy Pepsi stock and sell Coca Cola stock, assuming that the two companies would later return to their historical balance point. If the price of Pepsi rose to close that gap in price, the trader would make money on the Pepsi stock, while if the price of Coca Cola fell, he would make money on having shorted the Coca Cola stock.
[edit] Examples of potentially correlated pairs

Dow Jones (^DJI) and S&P500 (^GSPC) Coca-Cola (KO) and Pepsi (PEP) Wal-Mart (WMT) and Target Corporation (TGT) Dell (DELL) and Hewlett-Packard (HPQ) Exxon Mobil (XOM) and Chevron Corporation (CVX) Alliance and Leicester (AL.L) and Royal Bank of Scotland (RBS.L) Portugal Telecom (PTC.LS) and Telefonica (TEF.MC) Banco Comercial Portugus (MBC.LS) and Banco Portugus de Investimento (BPI.LS) RWE (RWE.DE) and E.ON (EOAN.DE) BHP Billiton Limited (BHP) and BHP Billiton plc (BBL)

[edit] Model-based pairs trading

Example of a portfolio spread forecast using an ARMA model and the associated forecast error bounds While it is commonly agreed that individual stock prices are difficult to forecast, there is evidence suggesting that it may be possible to forecast the pricethe spread seriesof certain stock portfolios. A common way to attempt this is by constructing the portfolio such that the spread series is a stationary process. To achieve spread stationarity in the context of pairs trading, where the portfolios only consist of two stocks, one can attempt to find a cointegration relationship between the two stock price series.[6] This would then allow for combining them into a portfolio with a stationary spread series.[7] Regardless of how the portfolio is constructed, if the spread series is a stationary processes, then it can be modeled, and subsequently forecasted, using techniques of time series analysis. Among those suitable for pairs trading areOrnstein-Uhlenbeck models,[8] autoregressive moving average (ARMA) models[9] and (vector) error correction models.[10] Forecastability of the portfolio spread series is useful for traders because: 1. The spread can be directly traded by buying and selling the stocks in the portfolio, and 2. The forecast and its error bounds (given by the model) yield an estimate of the return and risk associated with the trade. According to a paper of B. Do, R. Faff and K. Hamza, the success of pairs trading depends heavily on the modeling and forecasting of the spread time series.[11]
[edit] Market neutrality

The pairs trade helps to hedge sector- and market-risk. For example, if the whole market crashes, and the two stocks plummet along with it, the trade

should result in a gain on the short position and a negating loss on the long position, leaving the profit close to zero in spite of the large move. Pairs trade is a mean-reverting strategy, betting that the prices will eventually revert to their historical trends. Pairs trade is a substantially self-funding strategy, since the short sale proceeds may be used to create the long position.

[edit] Algorithmic pairs trading

Today, pairs trading is often conducted using algorithmic trading strategies on an Execution Management System. These strategies are typically built around models that define the spread based on historical data mining and analysis. The algorithm monitors for deviations in price, automatically buying and selling to capitalize on market inefficiencies. The advantage in terms of reaction time allows traders to take advantage of tighter spreads.
[edit] Drift and risk management

Trading pairs is not a risk-free strategy. The difficulty comes when prices of the two securities begin to drift apart, i.e. the spread begins to trend instead of reverting back to the original mean. Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setupa bet for reversion to the meanhas been invalidated. This can be achieved, for example, by forecasting the spread and exiting at forecast error bounds. A common way to model, and forecast, the spread for risk management purposes is by using autoregressive moving average models. Some other risks include: In market-neutral strategies, you are assuming that the CAPM model is valid and that BETA is a correct estimate of systematic risk if this is not the case, your hedge may not properly protect you in the event of a shift in the markets. Note there are other theories on how to estimate market risk such as the Fama-French Factors. Measures of market risk, such as BETA, are historical and could be very different in the future than they have been in the past. If you are implementing a mean reversion strategy, you are assuming that the mean will remain the same in the future as it has in the past. When the means change, it is sometimes referred to as drift

Pairs Trading Strategy for Indian Stock Market

September 26th, 2011 3 Comments Permalink
pairs-trading tutorial

We are pleased to announce that now you can analyse any pair of stocks using well-known pairs trading strategy at techpaisa. To the best of our knowledge, we are the first website in India to provide this utility online, and free of cost as of now. What is pairs trading? As the name suggests, pairs trading strategy works with a pair of stocks. First step is to find a pair of stocks or indices whose prices "move together". Moving together of price is technically known as cointegration. Idea is to find the pair of stocks which move together but occasionally, this pair will diverge from the average. Whenever a pair diverges from their mean, take positions in both the stocks (one long position and one short position). Gradually, when the prices of these stocks revert to the mean, exit the trades and book profit. Pairs trading is a market-neutral strategy. A market-neutral strategy means that profit doesn't depend on the direction of market. As long as the prices of pair of stocks revert to mean, you make money. How to choose pairs? First step in pairs trading strategy involves choosing pairs. We suggest you choose stocks from the same sector or subsector. Other pair could be to take one index and choose one of the constituent stocks. Example pairs: SBIN-AXISBANK, AMBUJACEM-ACC. You can also consider two indices as a pair. At techpaisa, you can do pairs trading here. When you have chosen a pair, use first stock as stock whose market capitalization is more than the second stock. We also give a confidence in statistics of finding pairs, always use pairs with atleast 60% confidence. How to do pairs trading? After you have chosen that a pair of stock prices move together, you have to wait for the prices to diverge from their mean. When the prices diverge from their mean, one stock become overvalued and the other undervalued. The bet is that undervalued stock will outperform the overvalued stock and prices will revert to mean. You take long positions in undervalued stock and short positions in overvalued stock. By doing this, your positions become market-neutral (at-least theoretically). Question is at what divergence, you will take positions, we suggest waiting for a divergence of at least 2 standard deviations from the mean. You can devise your own strategy. We strongly recommend you keep a target and a stop loss for your positions. Keep your target to the point where divergence reverts to 0.5 of standard deviation from mean. Keep your stop loss if divergence becomes 2.5 or 3 times standard deviation from mean. We backtest pairs trading strategy on historical data to find out optimal entry divergence and stop loss divergence. So for some pairs, you will find that entry divergence is different from +2 or -2.

Example We will take nifty and banknifty as an example. With 90% confidence, nifty and banknifty prices move together. NIFTY is STOCK1 and BANKNIFTY is STOCK2. Sequence of stocks in a pair matters because based on divergence and sequence of stocks we will determine which stock to long and which stock to short. In the chart below, prices of nifty and banknifty diverges at 2.01 (standardized error) times the standard deviation from mean. We take positions when standardized error is approaching 2 from above or -2 from below i.e. divergence is decreasing. In the figure below, divergence is approaching -2 from below which means STOCK2 (banknifty in this case) is undervalued (long banknifty) and STOCK1 (nifty) is overvalued.

In the chart below, we have the prices of nifty and banknifty.

We take positions on 7th January 2011. Since banknifty is undervalued and nifty is overvalued. We go Long BANKNIFTY and Short NIFTY. Quantities are also decided based on Cointegration Coefficient which we call slope on analysis page. Slope is 3, which means for every 100 stocks in banknifty, trade 300 stocks in nifty. In futures lots, that translates to 3 lots of nifty (150 stocks) and 2 lots of banknifty (50 stocks). Lets say we buy at the closing price of 7th January 2011 which is Rs. 5904 for NIFTY and Rs. 11053 for BANKNIFTY. We see that prices revert to mean after 7th January 2011 and if we close at our target of 0.5 standard deviation from mean, then that is reached on 24th January 2011. Price on that day is Rs 5743 for NIFTY and Rs. 11151 for BANKNIFTY. Our profit is (5904-5743)150 + (11151-11053)50 which is Rs 29050. As a general rule, if pair is STOCK1-STOCK2, and entry divergence is negative then LONG STOCK2 - SHORT STOCK1. If entry divergence is positive, LONG STOCK1 - SHORT STOCK2. You can employ your own strategy for closing trades like you close positions when the standardized error becomes zero i.e. prices revert to the mean exactly.

The market selloff and spike in volatility last week left many equity investors on edge after a relatively worry-free few months, but the renewed turbulence is less of a problem for those employing pair trading strategies, and may be an opportunity to profit should it continu

Volatile markets cause irrational behavior which creates opportunities to exploit, Charles Marleau, president and senior portfolio manager at Palos Management in Montreal, said in a commentary to clients

The reason why pair trading becomes our favourite strategy in a volatile market is because the strategy does not add additional systematic risk to the portfolio. The goal of pair trading is to match two stocks that are highly correlated. When the correlation between the two securities temporarily weakens one stock moves up while the other moves down the strategy is to short the outperforming equity and go long on the underperforming stock If the pair returns to its highly-correlated mean, a profit is made on one or both of the positions.