The pair trading strategy was opened in the 1980s by a group of quanta operating at Morgan Stanley. Since then, this strategy is the main one in many large investment banks and hedge funds. However, since large investors prefer not to share successful strategies with the public, pair trading has long remained unknown to the general public until the advent of the Internet. Now, with the spread of online trading, many trading strategies, including paired trading, have become available to ordinary traders.
What is paired trading?
The essence of the strategy is to find two trading instruments that have a high correlation and open counter positions on them each time the difference between their prices (taking into account the correction for the scaling factors) will exceed its average historical value by a given level. With this trade, the bet is made that the price difference will always tend to return to its average value, which means that profits will be earned at one or both positions. It is important to note that paired deals always remain neutral to the market, i.å. The general direction of the market does not affect their winnings or losses.
The pair trading strategy works well not only with stocks, but also with currencies, commodities and even options. Forex contracts for difference (CFD), which require significantly less diversion than the underlying asset, allow you to successfully use pair trading, including small investors.
How to choose couples?
The first step in developing a pair trading strategy is to search for two instruments that have a high correlation. Typically, this means that they must belong to the same industry or sector, but this is not necessary. As an example, consider the shares of two companies that have a high correlation: GM and Ford. Since both companies are American automakers, their shares tend to move together. To see this, it is enough to impose a graph of their prices on each other.
However, selecting couples, focusing only on economic analysis and fundamental indicators, is difficult and not always effective. Because, firstly, it is necessary to be an expert in this field and have a good understanding of the state of affairs of the companies in question, and secondly, even having the necessary knowledge and information, manually sort through many combinations of pairs of instruments to assess their suitability for pair trading, very laborious. In addition, relying only on fundamental considerations, it is possible to miss a lot of prospective pairs, connected by dependencies, the presence of which even an experienced analyst can not guess.
Therefore, institutional investors have long started to use in their practice various statistical methods for selecting promising pairs. The simplest and most well-known method is the calculation of pairwise correlation of instruments with the subsequent selection of pairs having a high correlation coefficient (more than 80%). Now on the Internet you can find a lot of services with already calculated correlations. For example, on the site megatrader.org there is an interactive correlation table of pairs with the possibility of plotting a pair.
How to trade?
Potential entry points in a position can be determined by plotting a spread between instruments. In this case, the spread is understood as the difference in prices of these instruments, taking into account the scaling factors. Coefficients are needed in order to bring the prices of instruments to commensurate values.
With the help of the spread schedule, it is easy to determine the moments of price divergence. To do this, it is enough to draw on the moving average chart a fairly long period – it will show the established historical price ratio of the instruments. And then – to track the deviation of the spread from this average. When there is a deviation greater than a given level, you can open a pair deal: take a long position on an undervalued instrument and a short one – overvalued. The optimal level can be easily determined using historical testing.
Pair trading is one of not many trading strategies that have proved themselves over time. Unlike various “shamanistic” methods of technical analysis, like graphical analysis, Elliott waves or Fibonacci numbers, this strategy has a strict scientific foundation. Detailed information about the pair trading and the ways of its implementation can be found here. Also on the site megatrader.org there are free services for auto-selection of pairs, greatly facilitating the construction of a trading strategy.