Introduction


Pair Trading is a very popular market neutral strategy which takes out volatility from the market where one exploits the trading pattern between two similar shares in an attempt to generate a low-risk profit. Without taking a view of the overall direction of the market Trader buys an under priced security and simultaneously sells an overpriced security where he finds a pair of securities whose prices moves together or is highly correlated. This is most often seen in shares of companies from the same sector; for example, direct competitors such as SBIN and ICICIBANK.

When prices diverge, he buys an under priced stock and simultaneously sells overpriced stock. Traders profit if prices converge, but lose money if prices diverge further. In this way, a trader bets on the relationship between two highly correlated stocks and not on the stock direction (up or down) of the market.

Apart from placing a short and a long position on the shares, variations on the basic concept of pairs trading may also be implemented in a variety of ways, including trading from a fundamental analysis perspective (e.g. placing a short position on a share trading at an above average PE to the benchmark and placing a long position on a rival trading below the average PE benchmark). Another variation involves going short on an index and going long on a stock that is expected to outperform that index, or going long on an index and short on a stock that is part of the index but expected to decline.

History


Pair Trading was developed in the 1980’s by a group of Quants at Morgan Stanley, who reportedly made over $50 million profit for the firm in 1987, using a contrarian strategy that tries to profit from the principles of mean-reversion processes.

Pair trading has also generated hundreds of millions of dollars in profits for companies such as Morgan Stanley and D.E. Shaw.

How to Pair trade


1) The first step is to choose two companies that you think are highly co-related.

2) The second step is to test quantitatively the share-price co-relation of the two securities being analyzed. As a thumb rule, the higher the co-relation, the better are the chances.

3) The next step is to calculate the ‘Price ratio’ or ‘Spread’ and find the two standard Deviations of ‘price’ or ‘spread’. Find the mean of them.

4) If Spread/Price Ratio (t) <= Mean Spread/Price Ratio – 2*Standard Deviation then go Long.

5) If Spread/Price Ratio (t) >= Mean Spread/Price Ratio + 2*Standard Deviation then go Short.

6) Wait for the prices to move towards standard deviation then exit from the trade.

Advantages


A major benefit of pair trading is that it is a ‘market neutral’ strategy. This means that a trader does not take a directional view on the market but, rather, makes decisions based purely on the price-relationship between the two chosen shares. So, it is a tension free strategy for a trader irrespective of the market going upwards, downwards or moving sideways. Naturally, the exposure to both the short and long position should be of equal weighting in order majorly to avoid any exposure to the overall market direction.

Disadvantages


Apart from risks associated with pair trading, the major disadvantage is that for each trade, the trader has to pay/bear double commission as he is traded in pairs. If a trader goes only long he pays only one commission, but here he has to long in one stock and at the same time need to short in another, so he has to pay double commission for both buy and sell. Paying twice for each trade may not make much of an impact if only a few pairs are traded over the course of a particular period of time, but when it becomes habitual, the dual fees and commissions add up very quickly.

And another disadvantage is that if the trader trades with low volumes trading stocks, Slippage, partial fills and bid-ask spreads can reduce profits.

How to overcome the Disadvantages of Pair Trading


Periodically need to check for the events before entering into the trade, need to exit if you are already in the trade if there is any event.

The trader has to choose a low priced broker where they are charging per trade but not per lot.

And the trader needs to choose the stocks always the group of high volume trading stocks, it’ll reduce the chances of slippage and partial fills.

Case Study


Once the historical price ratio or spread between two highly correlated companies has changed, assuming that this is a transitory inconsistency, one company can be perceived to be ‘undervalued’ and the other ‘overvalued’. A pair trader aims to profit in such a situation by exploiting the divergence in the share price of the pairs.

This is done by placing a long position on the ‘undervalued’ share and simultaneously placing a short position on the ‘overvalued’ share, with the intent of taking a profit when the price ratio or spread between the two securities converges back to its historical level. It is worth mentioning that one of the positions will, in all likelihood, end up making a loss. If one managed to implement correctly, however, the profit in the other position should more than compensate for the loss.