Market neutral pairs trading strategy
Traders have hundreds of technical tools and price action strategies to help them take advantage of price trends and ranging markets, but pairs trading is something completely different. Pairs trading uses correlations and divergences between two stocks in an attempt to capture a profit. While it isn't riskless, by understanding how pairs trading works, how you control risk and how you manage profits, it's a great tool to add to your trading arsenal because the strategy isn't dependant on market direction.
Pairs trading is when a simultaneous long position is taken in one stock while a short position is taken in another. The stocks must be highly correlated, meaning most of the time they move in the same direction. Typically, this is seen in the stocks of companies that are very similar, such as Coca-Cola Bottling Co.
KO and Pepsico Inc. PEP , or Ford F and General Motors GM. Since the stocks of these companies move in a similar fashion due to their similar business—we always must check to make sure they are moving in a similar fashion—when their stocks diverge it presents a trading opportunity. The strategy is to buy the stock that is underperforming and short-sell the one that is outperforming the other.
Doing this safely requires some research and risk controls. See also 25 Stocks Day Traders Love.
Algorithmic trading - Wikipedia
Before utilizing this strategy we first must see if two stocks are correlated. We want them to move in tandem most of the time; that way, when they diverge from one another, if history holds true, then eventually they will revert back to trading in tandem and a profit can be made. Figure 1 shows that over this time frame, Ford and General Motors often move in tandem. When they separated it presented an opportunity to short-sell GM when it was outperforming, and buy Ford when it was underperforming.
As long as the stocks eventually come back to trading in tandem then a profit is made. In this case they did. As long as the stocks separate and then come back together a profit is made, even if both stocks drop or both rally but get back in sync by doing it. Figure 2 shows the share price of Ford divided by the share price of General Motors. The ratio is currently 0. See also Trend Reversals: How to Spot and How to Trade.
Bollinger Bands are also applied periods and 2. The next section shows how to pick an entry and get out, but before that, position sizing must be addressed. The stocks are priced differently; according to current data General Motors is about twice as much as Ford. That way the exposure is the same, but the number of shares held in each will be different.
Consider the trade that occurred in December Ford declined steeply in value relative to GM, as is shown in both figures 1 and 2. On December 6, the ratio breaks below 2. Ford is falling and GM is rallying; the stocks are diverging. While a trade can be taken at the exact moment the ratio penetrates the 2. See also Analyzing Trading Volume: By waiting for the ratio to begin heading back toward the norm we avoid holding a losing position for longer than we need to in this case it would have been almost a month , and we can also place a stop below the recent low in our long trade and above the recent high in our short trade.
Therefore, enter trades when the ratio has gone beyond 2. Exit when the ratio comes within 0. Close out trade near the market close on January 24 because the ratio has moved to within 0. Therefore, we can conclude the price relationship has reestablished itself and our reason for entering the trade has now diminished. The short trade creates a cash inflow that offsets the outflow of the long position, so there is minimal cash outlay.
Not all pairs trades will work out this well; sometimes only one trade will be profitable and the other a loser, other times both trades may be unprofitable. The stop losses also contained risk to a small amount of capital, and the profit potential was much greater than the risk with these stops in place.
If either position gets stopped out, exit the other trade as well.
With this style of pairs trading you always have two positions or no positions. Pros include the strategy being market neutral. Just address the dynamic that is going on between the stocks and little regard or time needs to be committed to study of broader market conditions.
Pairs Trading Software - Pairtrade Finder
The strategy is also quite flexible; shorter term traders can use less of a standard deviation or a shorter time frame i. Cons include the possibility that a divergence can last much longer than expected, or the prices can simply continue to diverge based on fundamental changes in company structure or performance.
This is why a risk limit must be set to avoid catastrophe situations where the two stocks continue to move more and more out of sync. The strategy also goes against traditional trend trading concepts of buying the strongest stocks and selling the weakest — pairs trading does the opposite.
This strategy is also subjective. The price must diverge, and then we wait to take the trades until the prices start to converge again. While this is theoretically a safer approach, it takes skill and practice to develop that timing. Two similar stocks that have very different betas indicate a discrepancy in volatility. If one stock is much more volatile than the other it could cause issues with the trade. Ideally, pairs trade with stocks that are correlated and have similar betas.
Pairs trading involves taking a long and short trade simultaneously in two typically highly correlated stocks with similar volatility.
Pairs trade - Wikipedia
A long position is taken when one stock underperforms by a certain threshold, and a short trade is taken in the outperformer, with the intent that the stocks will eventually revert to the historical norm thus resulting in a profit.
If the stocks do revert to being highly correlated, the trade is profitable, but risk controls in the form of stops should be used to avoid situations where stocks continue to diverge.
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Home News Newsletter Articles Trader University Trading Securities Trading Platforms Trading Indicators Trading Strategies Lighter Side of TraderHQ Forex Trading TraderHQ. Cory Mitchell Sep 15, Pairs Trading Pairs trading is when a simultaneous long position is taken in one stock while a short position is taken in another. This is how the trade looks on the ratio chart. Get Email Updates Subscribe to receive FREE updates, insights and more, straight to your inbox.
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