Pair Trading

Nov 04, 2013 No Comments by

There are many strategies for traders in the market like straddle, strangle, butterfly spread etc. In 1980, Gerry Bamberger and Nunzio Tartaglia working in Morgan Stanley pioneered a new trading strategy and named it ‘PAIR TRADING’. Since then this strategy has been very widely used by hedge funds on a large scale.

So what is pair trading? As the name suggests that it is trading a pair i.e. two stocks at the same time. The trader picks out two stocks whose price historically has been correlated. This means that the two stocks’ relative movement has formed a pattern. The ratio of their price is expected to move in a range. Whenever it deviates to a particular side, higher or lower, it is expected to come back to the mean.

When the ratio is on the upper side it is expected to fall. Now this fall can come either by the numerator decreasing or the denominator increasing. So, the trader sells the numerator and buys the denominator. Any of the two things may happen but overall the loss in one will be offset by the profit in other and on net basis the trade yields profits. Similarly trade can be done when the ratio goes on the lower side.

Generally stocks of the same sector are pair traded like Infosys-TCS, HUL-ITC, SBI-ICICI etc. but this is not a rule. Stocks of different sectors also form pairs for trading. How to select these pairs? This is a very complex question. A very complex mathematical algorithm finds stocks which can be paired. We cannot pick two random stocks and tell that we will do pair trading in these. There are some basic mathematical parameters which they need to satisfy. There are many research papers published which tell us how to choose these pairs. Each hedge fund uses its own algorithm which it does not disclose. The beauty of pair trading is that by changing just a few parameters slightly the stocks picked completely changes. So, the pair chosen completely depends on the brilliance of the quant team of your fund. Let’s not get deep into the mathematics else we will miss the point.

Now we understand the basic concept of pair trading. So, is pair trading effective? Many research papers have been published proving that pair trading is effective. However, there is no yes or no answer to this question as hedge funds don’t release data about how much profit/loss they made depending on one strategy.

Just to give our view, pair trading is an excellent strategy if applied with some caution. Stock analysis has two parts – Fundamental Analysis and Technical Analysis. Fundamental Analysis deals with balance sheet and company analysis while Technical is the chart analysis. So, there are actually three confirmations before initiating a trade. First, from the pair trading algo confirmation has to come to initiate a trade. Let there be two companies – Infosys and TCS. Now the trade is telling that Infy should come down or TCS should go up. We do the technical and fundamental analysis of Infy and TCS. Our analysis gives Infy should come down then this is the second confirmation. Our analysis says TCS should go up, this is the third confirmation. So, if we have atleast two confirmations then the trade can be initiated.

In case of pair trade we should also keep in mind to check that if a stock is falling then is there some crisis in the company like Satyam. If we find such a problem no pair trade should be executed. The other thing we should keep in mind is to keep a stop loss. The loss is the stock which we have bought is limited to the buying amount. But the loss in the stock which we have sold can be unlimited. For eg. Short selling infy at Rs 3000 and buying TCS at Rs 1600. Maximum loss in TCS can be Rs 1600 if it becomes zero. If Infy becomes Rs 5000 loss is Rs 2000, if it becomes Rs 8000 loss is Rs 5000. There is no limit to the loss. So, keeping a stop loss is important.

At the end it comes to making profit. If the strategy is making profit, it is good else it is not. But while applying a strategy some basics should be kept in mind which maximizes the returns. Pair trading, if applied with these cautions can be a high return strategy.

Economy, Investment

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