A while back we published a pairs trade opportunity on the *Relatively Speaking mailing list for Sharenet Analytics clients. The status of the two pairs, which implied a long NED and short SBK is as follows:
Here is the status of the trade:
We are up on the long but down on our short, for a net gain of R4,190. This is a classic instance of the merits of pairs trading, since even though the short went against us, the trade was originated from a relatives position that would always make it likely that NED outperform SBK regardless of which direction they move. Of course, if our short was in profit this would be first prize but with pairs trading it’s not a necessity that the positions go in the way you expect them to. What’s important is that the one half of the pair out-performs the other regardless of direction.
By using relative pairs taken from the Sharenet Analytics Regression Trend Analyser (RTA) as discussed in the user guide, you significantly raise the odds of one share always outperforming the other, regardless of what direction they go and regardless of what direction the market goes (up, down or sideways). There’s a whole lot of diversification and risk reduction built into the trade than simply going long or short where you need to be right on the direction and also right that the general market does not move against you.
One more important fact. The long\short pair results in a neutral exposure. The long exposure is offset by the corresponding short exposure and the interest charged by your CFD provider on the long position gets significantly reduced by the interest you earn on your short position (interest you earn never matches interest you pay - like any loan/deposit with a bank!) This means your trade can take forever to realize and you won’t be penalised with daily margin exposure interest charges chewing into your precious profits!
So we have a market neutral, exposure neutral, high probability diversified trade that costs virtually nothing to execute/hold and can take its cotton-picking time to realize without eating into profits. What is not to like?
It’s no wonder that the Morgan Stanley quants division in the mid-1980s that pioneered this strategy made $80m in their first year.
With a pairs trade, you are actually trading the price of the one share divided by the other:
There are some caveats with pairs trading. The trick is to identify pairs that are supposed to be correlated (move in unison). Like two banks or two retailers or even shares within holding companies. Secondly, you need to inspect the news/fundamentals to find out if there are good reasons for the one share diverging unusually from the other. The less news or events or results that you think are causing the divergence the better. Also, you need to be aware of any dividends coming out on the share you are shorting as you will be liable for these dividends (instead of receiving them). If you are in the midst of a pairs trade and some results announcements are coming up, it may also be prudent to close out any profits you have since the results announcement could have an impact on the trade.
Read more about Sharenet Analytics’ new Regression Trend Analyser here.
*Relatively Speaking mailer:
A mailer sent 2-3 times per week that highlights opportunities from the RTA itself, so you don’t have to run the analyser yourself to find trading opportunities.
Dwaine van Vuuren
RecessionAlert, Sharenet Analytics
Dwaine van Vuuren is a full-time trader, global investor and stock-market researcher. His passion for numbers and keen research & analytic ability has helped grow RecessionALERT.com (US based) and PowerStocks Research (now Sharenet Analytics) into companies used by hundreds of hedge funds, brokerage firms, financial advisers and private investors around the world. An enthusiastic educator, he will have you trading and investing with confidence & discipline.