A beginners guide to pairs trading

What an incredible launch of the new year!  Market have plunged, rallied and then plunged again.

Stock prices are being tossed back and forth due to forces truly outside of our control.

Forces like oil prices, Chinese economic woes, and the ever changing landscape of U.S. corporate earnings are leading the market in 2016.

When the cyclically bullish pressure of the U.S. presidential election year is applied to the above chaos, it paints an extremely interesting year!

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The recent sharp market moves have forced investors to look for alternative techniques to help smooth their portfolio volatility.

One very effective method that is currently being employed by professional investors is called pair trading.

Pair trading is an easy to learn tactic that can help stock traders deal with the overall market volatility.

It is a very effective, market neutral trading tactic that is profitably used by winning investors that can be easily applied by anyone.

While this tactic is very popular among professional traders, most investors either don’t know about it or believe it’s too complicated to implement.  The truth is that this effective trading method is simple to understand despite having a complicated sounding name:

Every vocation has a secret language to create the impression that things are more intricate than they are.

Think about it, medical doctors use strange sounding Latin words to describe the most basic things.  Even every auto mechanic uses odd terms to describe basic engine parts.

Hedge funds and professional traders are no different. They have plenty of complex terms and words to describe simple things and ideas.

I know when I first learned the term pair trading it was intimidating.

The name itself makes it seem like one needs a Ph.D. or other advanced math degree to understand and profitably apply the idea. Nothing could be further from the truth.   While statistical arbitrage can be made complicated, it is an easy to comprehend and use the trading method.

What Is Pair Trading?

Pair trading is the buying or selling of two stocks based on their affiliation with each other.

Stock in the same sector or type of business often tracks each other very closely.

A pair trader discerns the price association between two stocks and buys or sells whenever the link gets out of sync having the knowledge that the historical correlation will likely continue.

The Academic Evidence:

Investopedia reports that in June of 1998, Yale School of Management released a paper written by Even G. Gatev, William Goetzmann, and K. Geert Rouwenhorst, who attempted to prove that pairs trading is profitable.

Using data from 1967 to 1997, the group discovered that over a six-month trading period, the pairs trade averaged a 12% return. To distinguish profitable results from plain luck, their test included conservative estimates of transaction costs and randomly selected pairs.
Like most things, a picture makes pair trading much easier to understand.

The following chart reveals the relationship between Coca-Cola (NYSE:KO) and Pepsi Co (NYSE:PEP).  These two stocks are very attractive stocks for pair trading due to their close relationship.

pepko

 

Observe how ideally the two stocks follow each other until the end of May.

At this time, Pepsi drops out of synch with Coca-Cola, plunging as Coca-Cola remains stable and begins to move higher.

Pair traders would purchase Pepsi stock as soon as the divergence is known.

As you can see, the pair rapidly progressed back into synch, providing profits for pair traders.

There are many angles how this can be implemented. For example, imagine that Coca-Cola started rapidly climbing higher than Pepsi.  Statistical arbitrage traders would short Coke betting that the price will fall back into the regular correlation.

Pair traders can also go long one stock and short another stock in the pair to profit from the price relationship.  There are numerous ways this market neutral strategy can be applied profitably.

Traders can use options, ETF’s, and futures as pair trading instruments.  The broad application of the same concept is one of the reasons that it is so popular for professional traders.

Not to mention that the basic concept is not just limited to two stocks.

The same idea can be applied to groups of 3, 4, 5 and even more correlated companies. However, advanced software programs are often employed to manage multiple stock pair trading.

Here’s another example of a well-known pair trade.

Walmart (NYSE:WMT) and Target (NYSE:TGT) are a commonly correlated stock pair.

wmttargett

As you can see, Target climbed out of the historical correlation series on the chart.  Traders using statistical arbitrage short Target, holding until the historical association came back into synch.

The coolest thing is that it’s not always obvious names that present enough correlation to pair trade.

One example of this is the strange price relationship of Citibank (NYSE:C) and Harley Davidson (NYSE:HOG).

citihog

Fundamentally, these companies could not be more different.  I cannot imagine two companies so diverse yet correlated so close.

Some traders believe that the reason for this correlation is because customers borrow money and buy Harley-Davidson motorcycles when they are optimistic.  However, the correlation likely has something to do with hidden hedge fund buying and selling of the pair that creates this very strange connection.

The truth is, the reason doesn’t matter for your bottom line.  Just the fact that you can recognize the correlation and act on it is all that is important.

It is critical to remember that pair trading is not fool proof.  Historical correlations do not always continue throughout time.

Also, stock pairs can stay out of synch for a substantial period or even forever depending on internal and external conditions.

Always position size properly and use stops no matter how certain you are of success when investing.  Pair trading is a hands-on method of investing.  It is not something that can be managed passively like holding index funds.  This means that is not for everyone.  If you don’t like actively managing your portfolio, pair trading is not for you.

What To Do Now:

Observe the pair charts of the common pairs like Coke (NYSE:KO) and Pepsi (NYSE:PEP), General Motors (NYSE:GM) and Ford (NYSE:F) and other closely related companies.

Experiment with finding correlated pairs by simply charting a variety of different company’s stock price pairs that you think may have a correlation.  Do not hesitate to use ETF’s in your search for correlated pairs.  There are also multiple on-line sources that provide correlated stock data.  Not to mention, some trading platforms have the ability to identify correlated stock pairs automatically.

The Key Takeaway:

Pair trading is a common hedge fund trading tactic that can be easily applied by every trader.  It is simply the trading of correlated pairs of stocks with the goal of the correlation continuing.

Academic studies and practical experience have proven that statistical arbitrage can be a profitable trading technique.  However, it is not for passive investors.  If you do not enjoy active trading, this method is not for you.

Commonly traded stock pairs include Coke and Pepsi, Target and Walmart, and even Harley Davidson and Citigroup. There are hundreds of possible pairs.  Traders can locate these pairs by observing price charts or by using software programs to locate correlations among stocks.

Although it can be an often profitable method, it is not foolproof.  Traders should always use stop losses and keep a close eye on the trades because even correlated stocks can remain out of synch for longer than expected.