Pair trading is a market-neutral trading strategy that seeks to generate returns irrespective of the direction in which the market is moving. The idea is to take a long position with a short position in a pair of highly correlated instruments. The trader goes long on the under-performer while simultaneously goes short on the over-performer. Traders wait for weakness in the correlation, a profit can be realized if the long position goes up more than the short, or the short position goes down more than the long.
When choosing pairs, it is advisable to choose stocks from the same sector or sub-sector. Other pair could be to take one index and choose one of the constituent stocks or even two stocks, exchange-traded funds (ETFs), currencies, commodities or options. The pair has to display a high degree of correlation. Any correlation above 0.8 is considered strong and anything less than 0.5 is considered weak. Once a position has been taken, the trader has to sit tight and wait for a divergence to happen. Correlation can often weaken temporarily because of various factors such as market inefficiencies, pricing mismatches and even currency exchange rates. A trader might take advantage of this divergence by shorting the over-performing issue and going long on the under-performing issue. A high degree of correlation would indicate that divergences are temporary and the stocks would revert to the statistical mean. A trader can earn a clean profit when the under-performing stock rises to its normal level or the over performing stock falls to its statistical mean. Price movements due to such weaknesses are extremely small and traders must enter large positions to make substantial profits.
Look at Correlation Coefficient for a pair and Buy one n Sell another.That’s it.We wish it would have been that easy.It’s not. Cointegration test is also required ( p value Hypothesis Test) to find that pair is stationary pair and statistically is mean reverting. Below is difference between these two factors. Below are the excerpts which we obtained from this Article. The difference is nicely explained.
What is the difference between correlation and cointegration?
When talking about statisitical arbitrage many people often get confused between correlation and cointegration.
- Correlation – If two stocks are correlated then if stock A has an upday then stock B will have an upday
- Cointegration – If two stocks are cointegrated then it is possible to form a stationary pair from some linear combination of stock A and B
One of the best explanations of cointegration is as follows: “A man leaves a pub to go home with his dog, the man is drunk and goes on a random walk, the dog also goes on a random walk. They approach a busy road and the man puts his dog on a lead, the man and the dog are now cointegrated. They can both go on random walks but the maximum distance they can move away from each other is fixed ie length of the lead”. So in essence the distance/spread between the man and his dog is fixed, also note from the story that the man and dog are still on a random walk, there is nothing to say if their movements are correlated or uncorrelated.With correlated stocks they will move in the same direction most of the time however the magnitude of the moves is unknown, this means that if you’re trading the spread between two stocks then the spread can keep growing and growing showing no signs of mean reversion. This is in contract to cointegration where we say the spread is “fixed” and that if the spread deviates from the “fixing” then it will mean revert.
( On lighter note – We wanted to have our own version using better half as a “PAIR”. But later found out that this example would be more risky than actual Pairs Trading Strategy. We might be putting ourselves in interrogation round to answer the n number of questions and the losses could be higher including non-monetary things. So everyone in group unanimously agreed to drop the idea and everyone took a sigh of relief. )
It is also important to consider that Spread is not increasing because there is fundamental change in the one of the asset. Then pair will not be mean reverting. When market is in trending mode then pair trading needs to applied cautiously. As with all the strategies, This strategy also has its shortcomings.
Pair trading requires well-researched strategies which are the result of accurate historical modeling, analysis and interpretation. Our experts at www.Intrinsicone.com have all the tools to help traders identify truly correlated n cointegrated pairs with maximum potential. Pair trading is one of our several strategies to help unlock value for our investors, irrespective of where the market is headed.