Pairs trading is a very specific trading strategy that allows you to be neutral in the market while still positioning yourself to profit from market movements. It is a strategy that works particularly well in a sideways or uncertain market, when you don’t have a high conviction of the general market direction.
So what is pairs trading exactly? Pairs trading is a market neutral strategy that matches a long position in a stock with a short position in another highly correlated stock.
There are a number of components that are required to formulate a successful pairs trading strategy, namely:
- A high correlation between the two shares
- Patience to wait for the relationship between the two shares to present an opportunity, and
- An accurate analytical tool to assist you in the timing of the trade.
Firstly, high correlation is critical. We’ve all heard the saying, "that’s like comparing apples with oranges". Well, for a successful pairs trade, you need to identify two shares from similar businesses that are influenced by the same or at worst very similar market conditions. In the example below, I have used Woolworths and Spar. Both are retailers operating primarily within South Africa, although both have foreign exposure. Both will be sensitive to changes in consumers’ disposable income.
Secondly, pairs trading requires patience on two fronts. You will need to wait for the correlated shares to "step out of line". In other words, wait until one share becomes historically expensive relative to the other. When the trades are placed, you will then need to be patient for the relationship to normalise again, trusting that the analysis you have followed is thorough and accurate.
This brings us to the most important part of the strategy - the analysis. Being able to find shares highly correlated to one another and then checking the historical relative performance is critical. This process can be time consuming and tedious. However, with the assistance of Sharenet Analytics and more specifically the Regression Trend Analyser (RTA), the process is practically effortless. This powerful tool will not only make the analysis process incredibly quick, it will also be highly accurate.
(Click image to enlarge)
The comparison of Woolies (blue line) Versus Spar (grey line) shows two opportunities. In December 2016, the RTA gave a buy WHL/sell SPP recommendation, as highlighted by the blue arrows. That pair was held until June 2017 where both positions were closed, yielding a profit of 9.2% on Woolies and 15.4% on Spar (remember you make profit when your short leg falls in price). The exit point for the pairs trade is highlighted by the red arrows, but it is also a signal to place yet another pairs trade. This time the signal is to buy SPP/sell WHL. This pair was held until November 2017, where it was unwound (blue arrows) yielding a profit of 20.8% on Spar and 19.1% on the Woolies short.
As mentioned earlier, the advantage of pairs trading is that you are neutral in the market by having a short equal in exposure to your long, allowing you to sleep well in the knowledge that you are largely isolated from dramatic overall market moves. Having a programme such as RTA is an invaluable tool in the analysis of correlations and relative performances - I personally couldn’t trade without it.
Neville has been a full-time client portfolio manager since 2002. He has completed a Unisa degree in Economics, The Registered Persons Exams (RPE’s), JSE Equity Traders Exam, RE5 (representative), RE1 (Key Individual) and RE3 (Hedge Funds). He has traded in numerous dealing rooms across South Africa, and has 16 year’s experience, his primary focus is on short-term trading strategies using derivative instruments.