Pair Trading

Pair trading is a market neutral trading strategy that profits from virtual market risk conditions such as sharp swings or sideways movements. Relative price movements between the stocks validate profits on trade. Also, pair trading is a hedge against individual fluctuations in the sector and the overall market where the stocks belong.

The strategy appears simple: long position in one stock combined with short position in the other. The combination of long and short positions in same sector limits the downside risk. Options are best proxies to stocks in pair trading, long calls as a substitute for long stock and long puts for short stock.

How to go about it? For instance, pick two stocks of the same sector that exhibits a mean reversion historically. In this case, we have an average spread between the stock moves over a period of time. As per the current spread, find out which stock is overpriced/underpriced and take long/short positions accordingly.

In order to have the best stocks picks for pair trading, the stocks should exhibit a strong positive correlation and betas; similar relationship over different time periods, the better. In this case, the loss in one position will offset by the gains in another. Additionally, timely entry and decision making skills could capitalize the opportunity, better.

Since both the stocks are of the same sector, the following are most likely:

Both will go up : i.e, stock with long positions will move faster than the one with short position.
Both will go down: i.e, stock with short positions will drop faster than one with long position.
In both the cases, one half will be a profitable trade and the other will result in losses; however, objective for the trade is that profits should exceed the losses.

Pair Trading - Examples

The pair trading is possible in many asset pairs, including the following:

  • DOW Jones vs. S&P 500
  • Silver vs. Copper
  • Gold vs. Silver
  • ExxonMobil vs. Chevron Corp
  • Pepsi vs. Coca-Cola

You can learn more about pair trading by reading our Gold: Silver Pair Trading report.