Hello and welcome to the world of pair-trading. You have come to the right place to learn about this versatile trading strategy. We have been specializing in it since 2008. My name is Alex, founder of ArbPairs, and I am delighted to be your guide in this journey.
Let’s start with the most basic trading concept that is crucial to the pair-trading strategy:
What is short selling?
To “short” a stock means to sell a “borrowed” security. To cover the short position, one needs to buy the security back. Therefore, when shorting, the expectation is for the security to depreciate in price so that the trade is profitable. Example: if 100 shares of stock X are “sold short” at $30, then regardless of what happens to the price, the trader “owes” 100 shares and will need to return them at some point. Profitability of the trade will depend on the price that the shares are bought back at when the position is closed. If position is liquidated when price falls to $29 then a profit of $100 will be realized due to the fact that 100 shares are returned and the trader gets to keep ($1 * 100) shares difference.
Why short selling is important for pair-trading?
When a position in a pair is initiated (long or short), one stock is bought and another is sold short nearly at the same time. This creates a dollar-neutral or hedged position because capital is allocated equally for both long and short sides of the trade. When a pair position is liquidated, the long stock is sold and the short stock is bought back.
What are stock pairs?
A stock pair is a combination of two stocks but it’s traded as a single entity. A pair can be bought, sold or sold short just like as if it was a single stock. Unlike currency pairs, stock pairs don’t have a truly binding relationship and can be de-coupled.
What’s the idea behind pair-trading?
The fundamental reasoning behind pair-trading is “capitalism”. Companies that serve the same market usually engage in similar business activities and underlying stock prices reflect this. You can see this by comparing how two stocks of competing companies move closely together:
Try it yourself with any company you’re familiar with and compare it against a competitor. You are likely to see that stock prices often move in tandem most of the times, but there are areas where stocks deviate from each other and then come back. Since companies compete against each other in the open market, it is common for one company to get ahead and for the competitors to catch-up. Or investor/trader sentiment may favor one over the other, either long or short term. That’s why pair traders watch for divergence in many different pairs to spot good trading opportunities. They try to find setups in pairs where spreads diverge and converge in a predictable manner. Pair-traders take advantage of such relationships and look for opportunities when stocks deviate. Whenever a position in a pair is opened at a point of significant deviation and prices mean-revert, the trade is closed for a profit.
Risks in pair-trading
It goes without saying that just like with regular trading there are risks with pair trading as well.
- The relationship in a pair may break or may not come to the mean in a long time
- Any short stock may become an acquisition target
- Pair-trading generates more commissions and requires more capital to trade successfully
Why trade pairs instead of single stocks?
- Market neutrality. When equal capital is put on both the long and the short stock, market direction becomes irrelevant. If the market goes up or down, both stocks are going to follow so a pair-trader’s only concern is the relationship between the two stocks. It takes away the “market risk”.
- Diminishing portfolio volatility. This is a risk management aid because instead of having highly volatile positions with single stocks, hedging helps negate large moves of individual stocks. Later on you will see a chart example where both stocks take a dive and yet the spread price remains stable.
- Taking advantage of market volatility. When market volatility is high, it makes individual stocks fly all over the place. The pair-trading strategy revolves around the concept of “reversion to the mean”, so excessive market volatility makes pairs deviate and revert to the mean more often.
- Predictability – good pairs move in a channel. If you can find a pair which shows consistent peaks and troughs around the same numbers, you can then attempt to capture the same points going forward.
- Variety of strategies
Types of pairs
The two most basic types of pairs are “ratio pairs” and “differential pairs”. They provide an alternative way of calculating the price of the pair.
Ratio pair price is one where the price of 1st stock is divided by price of the 2nd stock. Let’s say we have HD = $120 and LOW = $68.
Ratio = Price 1 / Price 2 = 120 / 68 = 1.7647
If we do it to every price in the series, we will get a chart like this:
The bottom section of the chart shows two stock prices, one on top of another. The upper chart is the ratio price.
Differential pair prices are created by subtracting the price of 1st stock from the price of the 2nd stock and a static ratio value is used to make the resulting price as close to zero as possible:
Spread price = Price 1 * Ratio – Price 2
For the same Hd Low example I am using a Ratio of 0.6. (In APM we use 60 for convenience and divide it by 100 in our spread price formula)
120 * 0.6 – 68 = 4
You can tell the type of pair by the number at the end of the pair name. Ratio pairs don’t have a number while differential pairs have a number that is the ratio multiplied by 100.
Notes on prices:
Ratio prices require four decimal places for precision, while spread prices can have just two. Spread prices reflect dollar-based price of the pair. In order to keep the spread price from going too far away from 0 (capital balanced position) the ratio value may need to be adjusted.
The calculation of the share amount X and Y is up to the trader when creating a new position. It can be done in line with the current ratio of the pair to equalize the capital on both sides of the trade, or one side can be over-weighted to have extra capital on the long or short side. When exiting the spread, the share amounts are not re-calculated but instead are taken from accounting record for the layer that is being liquidated.
How to make-up pairs?
Creation of pairs can be done by picking competing companies from the same sector and industry group. To line up more ducks for successful trades, one would also check pairs for fundamental and statistical validity.
How to trade pairs?
Pair-traders use software to watch a large list of pairs for divergence/convergence. Such software is used to set up alerts or execute pair trades when targets are reached. Targets can be set up manually or can be calculated by the software based on strategy parameters. When executing the trade, software sends both orders into the trading platform and takes care of accounting records for tracking PNL.
Buying the pair
If you were to BUY the HdLow at $4 spread price, the operation would involve buying X shares of HD (blue-colored chart) and shorting Y shares of LOW (green-colored stock).
To exit a long position in a pair, one needs to sell the pair. Selling HD and buying to cover Low would liquidate the long position in pair.
Shorting the pair
If you were to SHORT the HdLow at $4.40 spread price, the operation would involve shorting X shares of HD (blue) and buying Y shares of LOW (green)
To exit a short position in a pair, one needs to buy the pair. Buying to cover HD and selling Low would liquidate the short position in pair.
Types of pair-trading strategies:
- Statistical arbitrage – trading competing companies one against another with statistical edge
- Dividend capture – buying stocks ahead of ex-div dates to either capture the dividend move before the ex-div date or carry through the ex-div and close position after for profit or for scratch. For the latter option, the dividend will be transferred to the trading account at a later date.
- Merger arbitrage – trading stocks of companies that announced a merger
- Contractual pairs – trading different classes of stock that belong to the same company, such as Goog/Googl
- Liquidity arbitrage – trading lower liquidity stock vs correlated competitor or ETF. This strategy provides liquidity to the market and uses Limit orders.
- ETF pairs – trading stocks against ETF that they belong to
Please contact me or leave a comment below if anything is unclear.
Now that you have basic understanding of what pair trading is, you are ready for the next step: