Pairs trading

Description

Pairs trading is a swing trading strategy which tries to generate profits based on low risk trades. Long-short trading is another name for pairs trading because each trade consists of a related long and short position. These two positions can both be shares or a share and an index (market or sector). Nearly all institutional investors engage in pairs trading. Hedge funds always have a pairs trading fund in their product range.

Pairs trading tries to detect two instruments whose market price tends to evolve in tandem. These instruments are correlated. When, at one point in time, their prices no longer move in tandem (one goes up the other goes down, or one goes up a lot and the other just a little) traders assume the diversion is only temporary. The probability is high that the instruments return to their usual relationship and will start to move in tandem again. When diversion occurs traders will short sell the strongest performer and buy the weakest performer.

A pair trade is based on the price relationship between two correlated instruments. The evolution of the market is of secondary importance. For this reason some investors call it market neutral trading.

The strategy in detail

Institutional investors have many sophisticated ways via which interesting pairs can be detected (e.g. betas and other correlation data). This data mining is less accessible to the retail investor. However, by applying some common sense and a few tools the retail investor can already get very far. Logic dictates that there are categories of instruments in which correlated pairs appear more frequently. These categories are: shares operating in the same sector (e.g. two car manufacturers) and, a share versus its sector or market index. Our trading platform contains tools for pairs trading.

In order to visualize the relationship between two instruments it suffices to divide the price of one by the price of the other. This is called the relative performance. This example shows the relationship between Air France and the CAC40 market index over the last 12 months. The trader is interested in periods during which the correlation is high. To be significant these periods need to be at least two to three months long. During these periods the relative performance needs to move sideways in a tight range. In the case of Air France : CAC40 the period oct-nov-dec 2009 (green trend channel) meets these criteria.

Once a period during which the relative performance moves sideways for at least two to three months has been found, the wait for a break-out starts. The break-out needs to be of sufficient strength, at least the height of the trend channel (grey areas). In the case of Air France : CAC40 a break-out occurs at the end of January 2010 (red circle). The chart shows that Air France outperformed by far the CAC40 index. The trade consists of shorting Air France and buying the CAC40. The CAC40 position is closed with a small loss (green arrow). This loss is made good by the significant profit generated by the short position on Air France (red arrow).

This example plots two pharmaceutical giants, Novartis and Glaxo, against each other. During six months the relative performance moves sideways within a narrow range (green channel). Suddenly Novartis accelerates and Glaxo stumbles.  A relative performance break-out (red circle) occurs offering the potential for a pair trade. Reflect on the simple logic of this trade: Glaxo is (a) not likely to go out of business i.e. go to 0 and (b) will start to take measures to catch up with Novartis; Novartis on the other hand will not outperform indefinitely. Glaxo was the position to buy and Novartis the position to sell short. As expected their market prices evolved back towards each other and a profit was made on both the long position on Glaxo (green arrow) and the short position on Novartis (red arrow).

This example plots sporting goods company Adidas against the German market index DAX. During five months the relative performance moves sideways within a narrow range. Suddenly Adidas significantly outperforms the DAX index. The outperformance is of such strength that a relative performance break-out occurs (red circle). Adidas can be sold short against a long position in the DAX index. As expected Adidas cedes more ground later on. A profit is made on the short position on Adidas (red arrow). The long DAX position only breaks even (green arrow).

It is possible to use additional indicators to confirm the occurrence of relative performance break-out. Both MACD and Slow Stochastics have been integrated for this purpose. This screenshot shows the relative performance break-out out of narrow, protracted range coinciding with crosses in both the MACD and Slow Stochastics (note: the cross lies above the significant 80 line). These indicators can also play a role in the decision when to close the open positions.

Attention: It is crucial when pairs trading that both the open positions have the same size in money terms. If one position has a value of, say, £ 10.000 the other position’s value must be as close as possible to this amount. It is possible to work with shares which quote in different currencies. In this case you need to take into account the exchange rate to calculate each position’s size. Keep in mind that if you work with positions in different currencies changes in exchange rates can also influence your trade’s net result.

Our advanced Nanotrader Full platform contains a very practical tool called compound symbols. This tool allows traders to plot the relative performance of a pair in real-time. The trader can draw horizontal trend channels directly on the chart and set alarms at the break-out levels.

Conclusion

Pairs trading has a guaranteed place in the arsenal of most institutional investors given its potential for profits with low risk trades. Based on this, it is a technique worth mastering for the retail investor. A pair trade consists of two related positions, one long and one short. Profit or loss are a consequence of their relative price movements. The movement of the overall market is less relevant. The trading platform contain beautiful, free tools for the pairs trader.