Pairs trading is generally considered a market neutral strategy. Some traders use the strategy as a directional strategy. Pairs trading is one of many approaches a trader can use to reduce risk.
The strategy often combines a long position with a short position, using a pair of highly correlated assets. A pairs trade can use any two assets. Many times traders use assets such as two stocks, two exchange traded funds, two currencies, two commodities, two options, or two futures.
Any number of combinations can be used in pairs trading. Some examples are the FTSE verses the DAX, NDX against S&P 500, FedEx vs United Parcel Service, Home Depot vs. Lowes, etc.
Often these markets move together. A trader looks for some type of correlation between the two assets. The two assets will not be completely correlated. When there is an up or bullish day, both assets generally go up in price. The same goes if there is a bearish day, both assets will generally go down in price.
Controlling risk is very important. A pairs trade must be constructed within the guidelines of the trader's risk tolerance.
Today’s example refers to pairs trading as a market neutral strategy using stock.
Pairs traders using stock as the underlying asset often look for a variation in the correlation between the two assets. A trader may elect to enter long on the asset which they feel will rise in price. At the same time, they will short the asset which they feel will go down in price.
In a market neutral strategy, the profit on a pairs trade is realized from the difference in the price change between the two assets. The relationship between the two assets has changed, resulting in a profit or loss.
Profits using stock as the underlying asset can accrue if:
- The long asset increases more than the short asset.
- The short asset decreases more than the long asset.
- The long asset goes up, and the short asset goes down.
A pairs trader can realize a profit in many different market climates and volatilities.
Because the strategy pairs one asset in correlation to another asset, it reduces market exposure. This tends to produce a hedge against market risk.
The market neutral pairs trade takes away some of the market risk because the risk is applied to the relationship between the long and short asset and not the overall market.
A market neutral pairs trade is not concerned with which direction the market moves, so directional risk is less. The profit is realized by the difference in price change between the two assets and not the market itself.
Divergence in a Pairs Trade …
Some traders will enter a pairs trade when there is divergence. Divergence can be caused by a big move in one asset while the other asset does not move much in price. Sometimes both assets will move in opposite directions which cause divergence.
If the trade is entered on a divergence basis, the trader would be hoping that the correlation between the two assets will revert back to the mean.
Figure A. Chart showing the relationship of GOOG and /NQ.
In figure A the green and red line depicts the price movement of GOOG. The purple line depicts the price movement of /NQ.
Divergence is the difference in the price plot of /NQ and GOOG is indicated on the chart in Figure A.
This divergence for some traders indicates a good entry point for a pairs trade.
The trader could enter the position with the hope that /NQ and GOOG would revert back to the mean.
A trader can construct a directional pairs trade.
To do this, the trader would determine the ratio between the two assets. From the ratio, the position can lean towards the directional bias of the trader.
For example, a trader feels XYZ stock at a price of 100, is more bullish than ABC stock with a price of 50. XYZ stock has a 2 to 1 ratio when compared to ABC stock. Therefore the position is weighted bullish on XYZ stock.
How does a trader calculate the ratio for the two pairs?
The ratio for each asset in a pairs trade is calculated by determining the notional value of each underlying asset.
The notional value is important because a trader needs to know how much leverage is being controlled. This is helpful in the event the trade goes against the trader. It helps to define risk.
How to determine the notional value of a futures contract…
A futures notional value is equal to the dollar value of one futures contract.
The future /ES $ dollar value is $50. Let’s say the current price of ES is 2800.
To calculate the notional value, multiply the dollar per point which is 50, times the current price which is 2800. This equals the notional value of $140,000.
Pairs trades can be constructed using stocks and futures.
Let’s use /NQ and GOOG as an example. The futures symbol for the Nasdaq is /NQ.
Let’s say NQ is currently trading at 7180.00 and GOOG is trading at 1166.00.
To determine an approximate 1 to 1 ratio for /NQ and GOOG, a trader would divide 7180 by 1166. This equals 6.15. Therefore the approximate one to one ratio would be 1 contract of /NQ and 6 contracts of GOOG.
1 contract: NQ = 7180.00
6 shares GOOG= 6996.00
What are Some Advantages of Pairs Trading?
- Market neutral strategy – The spread or difference between the two assets can be traded.
- The strategy can also be traded directionally.
- In general there is less volatility in the trade.
- The trade can be scaled to help offset some of the risk.
What are some Disadvantages of Pairs Trading?
- Controlling risk can be hard at times.
- Margin on the trade can be high. Two assets are being traded so there is margin on each asset.
- Commissions can be costly due to two assets.
- Execution can be challenging- partial fills and slippage can occur.
In Summary…
The subject of pairs trading is enormous. This article has given you some insight of the world of pairs trading.
Pairs traders often look for an opportunity where the two instruments are acting in an abnormal relationship to each other. When this relationship begins to fail, pairs traders can buy long the instrument, which is performing weakly, and short the instrument which is performing strongly. Once the relationship of the two instruments returns back to its statistical norm, the trade can be closed.
Pairs trades can also be executed directionally.
Determining the correct ratio of a pairs trade is important. From the ratio, a trader can build the position according to the determined directional or neutral bias.
There is a very good Round Table discussion on ViPars. This is a pairs trading strategy. Go to Round Table with Scott Ruble | Introduction to ViPars.
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