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 101
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.
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Pairs Trading Considerations
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.
Overall market direction doesn’t matter. 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.
That’s the theory, but deciding when to take a pairs trade, how to control risk, and when to take profit is a more precise matter.
Stockcharts.com allows you to plot a chart that shows the ratio of one stock compared to another. Figure 2 shows the share price of Ford divided by the share price of General Motors. The ratio is currently 0.51, meaning Ford is almost exactly half the price of GM.
A 200-day period moving average is applied to get a “normal” ratio (currently 0.45). Bollinger Bands are also applied (200 periods and 2.5 standard deviations) to spot times when the ratio has moved significantly away from the norm, offering a trading opportunity.
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. This means we can’t buy the same number of shares in each, we must calibrate each position.
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The easiest way to determine position size is to set a fixed dollar amount for each side of the trade, say $10,000. Buy $10,000 worth of one stock and sell $10,000 worth of the other stock. That way the exposure is the same, but the number of shares held in each will be different.
Pairs Trading Example Explained
Consider the trade that occurred in December 2013. Ford declined steeply in value relative to GM, as is shown in both figures 1 and 2.
On December 6, the ratio breaks below 2.5 standard deviations (lower red Bollinger Bands) from the 200-day norm. 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 2.5 standard deviation Bollinger Band, it is prudent to wait for both the stock prices and the ratio to start converging (moving back toward normal) again before taking the trade.
In this case, we don’t see the ratio begin to trend back higher until January 2. 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 2.5 standard deviations from the 200-day norm and is starting to move back toward the norm. Exit when the ratio comes within 0.02 points of 200-day norm.
This is how the trade looks on the ratio chart.
Buy Ford near the close on January 2 at $15.44. Place a stop loss below the recent low at $15.10.
Short-sell GM near the close on January 2 at $40.95. Place a stop above the recent high at $41.85.
If each side of the trade is allocated $10,000, then we buy 647 shares of Ford ($10,000 / $15.44) and sell 244 shares of General Motors ($10,000 / $40.95).
Close out trade near the market close on January 24 because the ratio has moved to within 0.02 of the norm (200-day average). Therefore, we can conclude the price relationship has reestablished itself and our reason for entering the trade has now diminished.
GM is closed at $36.83 and Ford at $15.83.
Profit collected is:
General Motors: $40.95 – $36.83 = $4.12 × 244 shares = $1,005.28
Ford: $15.83 – $15.44 = 0.39 × 647 = $252.33
Net Profit: $1,005.28 + $252.33 = $1,257.61
The short trade creates a cash inflow that offsets the outflow of the long position, so there is minimal cash outlay. If calculating the return based on the initial $20,000 in positions though, the return is greater than 6% in less than a month.
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 and Cons of Pairs Trading
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. The strategy is also quite flexible; shorter term traders can use less of a standard deviation or a shorter time frame (i.e. 30-minute chart) to trigger more trade signals.
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.
Traders must also consider a stock’s beta. 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.
The Bottom Line
Pairs trading involves taking a long and short trade simultaneously in two typically highly correlated stocks with similar volatility. 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. Reversions to the norm can take a long time, so traders must weigh which trades are worth the potential wait and risk, and which aren’t.
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