What is Pair Trading? How does it work?

The Origins of Pairs Trading

The first of such trading is generally credited to a group of computer scientists, mathematicians, and physicists assembled by  Morgan Stanley & Co. in the mid-1980s. The team was brought together to study arbitrage opportunities, employing advanced statistical modeling and developing an automated trading program to exploit temporary market imbalances. While the team’s resulting black box was traded successfully in 1987 – the group made a reported $50 million profit for Morgan Stanley – the next two years of trading saw poor enough results that in 1989 the group disbanded!

Over the years, pairs trading has gained modest attention among individual, institutional, and hedge fund traders as a market-neutral investment strategy.

Today, by using technology as well as drawing on fundamentals, probabilities, statistics, and technical analysis – pairs traders attempt to identify relationships between two instruments, determine the direction of the relationship and execute trades based on the data presented.

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What is Pair Trading?

Pair trading involves undertaking a long and short position in stocks that have a high correlation. A relatable example of pair trading can be compared with an interstate highway and service road.

Generally, the main highway is a long, concrete road whereas the service road runs parallel to the highway on either side. The service road provides access to shops, houses, farms, and commercial and industrial areas along the highway. Both roads run parallelly on either side. If the highway is inclined in a particular direction, so is the service road. The path followed is similar except for minor obstructions on the service road, which could be a tree or a pole.

Pair trading works in a similar way where the stocks you purchase belong to a similar industry but different companies or brands.

Various attributes of pair trading
The features of pair trading when correlated to the example mentioned above include:

Securities
The highway and service road are securities in which you can invest. Let’s consider Stock A & B.

Relationship
The relationship between the highway and service road depicts the relationship between Stock A & B. Market impact on Stock A will be similar to that of Stock B. Both stocks behave in a similar manner.

Relationship deviation
Similar to obstruction on the service road, there may be events that will lead to a breaking in the correlation between the stocks.

Impact of deviation
The deviation in correlation tends to be short-lived and the stocks promptly recover their relationship.

Let’s consider two companies – Hero MotoCorp and Bajaj Auto:

1. Both are private companies in the automobile industry in India.
2. Both have similar products, target audiences, and customers.
3. Both have similar volumes, and presence in India.
4. Both face similar challenges, regulations, and constraints.

Both are highly correlated. Thus, a change in market conditions will have a similar impact on both companies. For example, an increase in the price of fuel will have a negative impact not only on the industry but also on the companies. Considering everything else to be equal, if the stock price of Hero MotoCorp moves in a particular direction, in all probability, the stock price of Bajaj Auto will also move in the same direction.

However, if the stock price of the two companies does not move in the same direction, this is the ideal trading opportunity. Herein lies the crux of pair trading. Therefore, pair trading usually revolves around the following strategies:

1. Identifying the relationship between stocks
Many investors will look for securities in the same sector or industry group. The correlation between companies in different sectors tends to be lower. For example, a change in the raw materials required for automobiles will have an impact on Hero Moto but not on HDFC bank.

2. Analyzing the correlation between the stocks
A correlation of 0.85 is considered to be adequate while entering into a pair trade. Hero Moto and Bajaj Finance have displayed a correlation of 0.87 over the last year.

3. Tracking the correlation on a daily basis
Correlation refers to the degree to which two variables are dependent on each other or move in coordination with one another. The correlation coefficient ranges from -1 to 1. A correlation of -1 indicated that the securities have a perfect negative correlation i.e. if one increases by 50% the other falls by 50%. A value of zero means there is no correlation and a value of 1 means there is a perfect positive correlation.

4. Checking for anomalies in correlation
Lastly, one has to identify opportunities to trade. Tracking the deviation in the correlation helps to access opportunities for trading. These may be intraday or long-term.

What is pair trading in the stock market?
As discussed above, an anomaly in correlated securities provides a trading opportunity. The reason for anomalies in prices could be a result of various factors such as excessive speculation in trading, the announcement of quarterly results, changes in top management, etc. A pair trading strategy essentially involves identifying such anomalies and executing a long position in one and a short position in the other to benefit from the temporarily weakened correlation. The idea is to take benefit of the temporary deviation in correlation assuming that the gap would recover to its original state.

In stock pair trading, a long position is to be executed for the underperforming security and a short sell for the outperforming security. If the securities return to their original correlation, that’s where the profit lies. Thus, the entry and exit points in pair trading are clearly defined.

To illustrate the potential of profit from pair trading, consider two securities – ICICI Bank and HDFC Bank which historically have a high correlation of 0.95. RBI issues guidelines to HDFC Bank with respect to issuing credit cards. Consequently, the price of HDFC Bank falls sharply and the correlation between the securities reduces in the short term to 0.50. In this case, the trader will take a long position on HDFC Bank and short-sell ICICI Bank. With the passage of time, the price of HDFC Bank recovers, and the correlation between the two securities is returns to 0.95. The trader benefits from the long position and the closed short position.

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What are the benefits of pairs trading?

The strategy has several positive elements. Firstly, the matching of a long position with a short one in a correlated instrument creates an immediate hedge, with each part of the trade acting as a hedge against the other. The risk of the trade is therefore controlled to a degree but is not eliminated entirely. For example, when long and short are two companies in the same sector, if both prices fall, then the money made in a short position offsets the loss in the long position.

In addition, the strategy can be successful in up, down, and sideways markets. The strategy is not dependent on market direction, but rather on the correlation between the two markets. The relative performance of the two markets is the key element, and not just whether the market goes up or down, as is the case for those traders that only go long or short.

The strategy has reduced directional risk since a trader that goes long or short faces the possibility that the market will move in an opposite direction to that of the trade. But in pairs trading the second position is a hedge against the first, cutting back on the risk.

Pairs trading also features smaller drawdowns. A trade that sees profits of £1000 on one day, but then the second day sees that fall to £500 has a drawdown of £500. But the loss in one position is tempered by profits in the other, and thus the expected drawdown of the strategy can be smaller.

What you need to know before pairs trading

While it sounds like an ideal strategy to avoid the risks of uni-directional trading, pair trading is not a magic formula. It will not work each and every time. Correlations can change over time, so as ever it is important to manage risk correctly, risking only 2% of your capital on each trade. Indeed, given that a pairs trader is using two rather than one positions, perhaps this should be dialed down to 1% of capital for each trade.

Two markets with no correlation are like two dogs running around together in a park. They are both wandering around, but they are both independent so there is no meaningful connection to their movements. However, a man walking his dog is an example of correlated movement. The dog may wander away from the man, but it will eventually come back. The man and his dog are correlated, and the times when the dog moves away from the man are examples of the ratio between two markets becoming stretched.

Pairs trading risks

Pairs trading relies on mean reversion. A trader is buying the underperformer and selling the outperformer, on the basis that this relationship will change course in due course. However, financial markets are constantly changing, and there are times when the relationship evolves, and the under/over-valuation does not mean revert.

For example, Ford and General Motors (GM) were closely correlated in the years before the financial crisis, but in 2008 a trader that was long General Motors and short Ford would have seen the ratio go to zero when GM went bankrupt. In addition, with pairs trading, you are paying the spread twice, thus increasing your trading costs. Finally, the ‘anomaly’ in the ratio that gave rise to the pairs trade in the first place may go on for longer than planned or continue to increase, resulting in an unsuccessful trade or one that is stopped.

Pros and Cons of Pairs Trading

Pros include the strategy being market neutral. – little regard or time needs to be committed to studying of broader market conditions. The strategy is also quite flexible; shorter-term traders can use less of a standard deviation or a shorter time frame (i.e. 30-minute chart) to trigger more trade signals.

Cons include the possibility that divergence can last much longer than expected, or the prices can simply continue to diverge based on fundamental changes in company structure or performance. This is why a risk limit must be set to avoid catastrophe situations where the two stocks continue to move more and more out of sync.

The strategy also goes against traditional trend trading concepts of buying the strongest stocks and selling the weakest – pairs trading does the opposite. So sometimes it’s counterintuitive and uncomfortable!

Traders must also consider a stock’s beta. Two similar stocks that have very different betas indicate a discrepancy in volatility. If one stock is much more volatile than the other it could cause issues with the trade. Ideally, pairs trade with stocks that are correlated and have similar betas.

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