What Is Pair Trading?

21 November 2018 | Juan Breytenbach
 


"Pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy" - Wikipedia, Pairs Trade

The strategy monitors two historically correlated stocks, usually in the same sector. When the correlation weakens, the spread between the two stocks widens. In other words, the stocks are affected similarly by the economy, market sentiment, currency, etc.

The idea is to buy the underperformer and short the share that is the outperformer, expecting that the spread between the two securities will start to converge, narrowing the spread back to the norm and turning a profit. The potential outcomes of both legs are irrelevant: it is the cumulative gain (after brokerage, carry cost and dividends received and paid out) on both legs which is important.

Pair trading or market neutral strategies have been around for a very long time, but with the big boom of the hedge fund industry in the 1980s and the increase in computing power, more traders started to explore and experiment with these new strategies in order to hunt more alpha. Most notably in the 1980s, a group of quantitative traders from Morgan Stanley apparently used this strategy in order to yield over $50 000 000 profit for the firm in 1987 alone.

An example

Pair trading by definition follows a “mean reverting” process in identifying the trades. The easiest way to explain pair trading is to use an example.

Below is a chart of SBK (Standard Bank Group Limited) using DMA charts on our trading platform:

(Click image to enlarge)image1

Standard bank SBKJ.J (Reuters RIC)

  • Percentage move this year: 6.68%
  • Year to date move: -11.07%
  • Yield: 5.33%
  • EPS: 16.44
  • PE: 10.74
  • Beta 1.02
  • Bullish MA count: 2
  • Bearish MA count: 1
  • Next earnings date: 7 March 2019
  • Next dividend date: 11 April 2019
  • Market Cap: 286,832 Million
  • Free float: 99.9%

Next we have a chart of FirstRand:

(Click image to enlarge)image2

FirstRand Limited FSRJ.J (Reuters RIC)

  • Percentage move this year: 31.46%
  • Move year to date: 1.52%
  • Yield: 3.96%
  • EPS: 4.73
  • PE: 14.66
  • Beta 1.08
  • Bullish MA count: 3
  • Bearish MA count: 0
  • Next earnings date: 4 March 2019
  • Next dividend date: 7 Feb 2019
  • Market Cap: 329,793 Million
  • Free float: 56.5%

Once you have had a look at the basic fundamentals and news, when the next earnings date is, when the next dividend will be posted, and so on, you would then work out the pair.

The two most popular methods of working out the pair are using the spread or the ratio:

  1. Spread = Subtract the one share price from the other
  2. Ratio = Divide the one share price by the other

Some strategies even advocate a beta neutral approach.

I prefer looking at the ratio as it’s the simplest. The ratio is calculated by dividing the share price you are going to go long on by the share price you’re going to short. So in the example, I would like to see if going long on Standard Bank and shorting FirstRand is a feasible idea.

In the graph below, I created an easy overlay of both SBKJ.J (in black) and FSRJ.J (in orange). We can see that they are relatively closely correlated over the last while.

(Click image to enlarge)image3

Another great part of DMA’s trading platform is that one can work out the ratio very easily:

(Click image to enlarge)image4

The line graph below is the price of SBKJ.J divided by FSRJ.J:

(Click image to enlarge)image5

If you expect the ratio to go down 10%, and it goes below 10%, this is where you would like to take a stop and close the position out. You would need to work out how much you will be willing to lose per trade.

(Click image to enlarge)table1

Let’s say hypothetically you’re willing to risk a 10.59% move in the ratio. If you go long the NAV will be R47 214.35 worth of SBK, and go short the NAV will be R47 214.35 worth of FSR.

How many shares I should buy or short?

Let’s say the price of Standard Bank is trading at R174.38 per share and the price of First Rand is R68.45 per share. Dividing the NAV by the price of the share will give you how many shares to buy or short.

(Click image to enlarge)table2

So to put this pair on long (buy) SBKJ.J 270 shares and short (sell) FSRJ.J 689 shares, and the price appreciates 10.59%, your profit before cost will be approximately R5000.00.

Something to account for is the brokerage fee you will need to cover, and the distance to target or stop loss.  Bear in mind the risk of slippage, as you won’t always have a true 100% pair.

Also remember that on shorts you earn interest, and you pay out interest on longs, so this makes it cheaper to hold both long and shorts (pairs) than a complete long-only portfolio in the market.

Lastly, be aware that this style of trading can take out:

  • Market risk: It doesn’t matter what the general market does, you’re worried about the relationship between the two shares.
  • Currency risk: A lot of our share are big rand hedges. If you’re afraid the rand will impact your trade, find another rand hedge to pair it up with.
  • Volatility, and profit and loss swings in the portfolio
  • Sector risk

Closing thoughts

My description here is not the only way to trade pairs, nor am I saying this is the best strategy to follow. The main purpose of this article is to explain that you can trade pairs just like normal stocks, and shows how similar this strategy is compared to buying or shorting normal CFDs.

Adding multiple strategies when trading the markets helps to diversify out the risk. At Sharenet this is one of the strategies that we follow and trade.

If you are interested in following this style of trading and developing more as a trader by learning new styles and strategies, please contact us.

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Juan Breytenbach
Sales Trader : Sharenet Johannesburg

Steen Jakobsen first joined Saxo Bank in 2000 and has served as both Chief Economist and Chief Investment Officer since 2009. He focuses on delivering asset allocation strategies and analysis of the overall macroeconomic and political landscape as defined by fundamentals, market sentiment and technical developments in the charts. With more than 25 years of experience within the fields of trading and investment, Jakobsen is a highly renowned and respected Chief Economist, who regularly appears as a guest host on CNBC and Bloomberg News. Prior to joining Saxo Bank, he worked with Swiss Bank Corp, Citibank, Chase Manhattan and UBS. He also served as Global Head of Trading, FX and Options at Christiania (now Nordea).


Disclaimer:
The information contained in this article is for informational purposes only and must not be regarded as a prospectus for any security, financial product or transaction. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial issue. Investors should consider this research/article as only a single factor in making their investment decision. We recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs. The views and opinions (where expressed) in this article are those of the author and do not necessarily reflect the official policy or position of Sharenet.