Pairs trade
Encyclopedia
The pairs trade or 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. The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley
in the 1980s.
The strategy monitors performance of two historically correlated securities. When the correlation
between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the "spread" between the two would eventually converge. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.
Pairs trading strategy demands good position sizing, market timing
, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity.
A notable pairs trader was hedge fund Long-Term Capital Management
.
. To achieve spread stationarity in the context of pairs trading, where the portfolios only consist of two stocks, one can attempt to find a cointegration
relationship between the two stock price series. This would then allow for combining them into a portfolio with a stationary spread series. Regardless of how the portfolio is constructed, if the spread series is a stationary processes, then it can be modeled, and subsequently forecasted, using techniques of time series analysis. Among those suitable for pairs trading are Ornstein-Uhlenbeck models, autoregressive moving average (ARMA) models and (vector) error correction models. Forecastability of the portfolio spread series is useful for traders because:
According to a paper of B. Do, R. Faff and K. Hamza, the success of pairs trading depends heavily on the modeling and forecasting of the spread time series.
on an Execution Management System
. These strategies are typically built around models that define the spread based on historical data mining and analysis. The algorithm monitors for deviations in price, automatically buying and selling to capitalize on market inefficiencies. The advantage in terms of reaction time allows traders to take advantage of tighter spreads.
Market neutral
An investment strategy or portfolio is considered market neutral if it seeks to entirely avoid some form of market risk, typically by hedging. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided...
trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage
Statistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
and convergence trading strategy. The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
in the 1980s.
The strategy monitors performance of two historically correlated securities. When the correlation
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the underperforming one, betting that the "spread" between the two would eventually converge. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.
Pairs trading strategy demands good position sizing, market timing
Market timing
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...
, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity.
A notable pairs trader was hedge fund Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
.
Examples of potentially correlated pairs
- Dow Jones (^DJI) and S&P500 (^GSPC)
- Coca-ColaCoca-ColaCoca-Cola is a carbonated soft drink sold in stores, restaurants, and vending machines in more than 200 countries. It is produced by The Coca-Cola Company of Atlanta, Georgia, and is often referred to simply as Coke...
(KO) and PepsiPepsiPepsi is a carbonated soft drink that is produced and manufactured by PepsiCo...
(PEP) - Wal-MartWal-MartWal-Mart Stores, Inc. , branded as Walmart since 2008 and Wal-Mart before then, is an American public multinational corporation that runs chains of large discount department stores and warehouse stores. The company is the world's 18th largest public corporation, according to the Forbes Global 2000...
(WMT) and Target CorporationTarget CorporationTarget Corporation, doing business as Target, is an American retailing company headquartered in Minneapolis, Minnesota. It is the second-largest discount retailer in the United States, behind Walmart. The company is ranked at number 33 on the Fortune 500 and is a component of the Standard & Poor's...
(TGT) - DellDellDell, Inc. is an American multinational information technology corporation based in 1 Dell Way, Round Rock, Texas, United States, that develops, sells and supports computers and related products and services. Bearing the name of its founder, Michael Dell, the company is one of the largest...
(DELL) and Hewlett-PackardHewlett-PackardHewlett-Packard Company or HP is an American multinational information technology corporation headquartered in Palo Alto, California, USA that provides products, technologies, softwares, solutions and services to consumers, small- and medium-sized businesses and large enterprises, including...
(HPQ) - Exxon Mobil (XOM) and Chevron CorporationChevron CorporationChevron Corporation is an American multinational energy corporation headquartered in San Ramon, California, United States and active in more than 180 countries. It is engaged in every aspect of the oil, gas, and geothermal energy industries, including exploration and production; refining,...
(CVX) - Alliance and Leicester (AL.L) and Royal Bank of ScotlandRoyal Bank of ScotlandThe Royal Bank of Scotland Group is a British banking and insurance holding company in which the UK Government holds an 84% stake. This stake is held and managed through UK Financial Investments Limited, whose voting rights are limited to 75% in order for the bank to retain its listing on the...
(RBS.L) - Portugal TelecomPortugal TelecomPortugal Telecom is the largest telecommunications service provider in Portugal. Although it operates mainly in Portugal and Brazil, it has also a significant presence in Guinea-Bissau, Cape Verde, Mozambique, Timor-Leste, Angola, Kenya, the People's Republic of China, and São Tomé and...
(PTC.LS) and TelefonicaTelefónicaTelefónica, S.A. is a Spanish broadband and telecommunications provider in Europe and Latin America. Operating globally, it is the third largest provider in the world...
(TEF.MC) - Banco Comercial PortuguêsBanco Comercial PortuguêsBanco Comercial Português , is a Portuguese bank that was founded in 1985 and is the largest private bank in the country. BCP is a member of the Euronext 100 stock index and its current chief executive officer is Carlos Santos Ferreira. BCP is based in Porto, but its operations are headquartered...
(MBC.LS) and Banco Português de InvestimentoBanco Português de InvestimentoBanco Português de Investimento is a major privately owned bank in Portugal. The bank's shares are listed in the Euronext Lisbon's PSI-20 stock index. It runs the banking business with companies, institutional and private clients. As Sociedade Portuguesa de Investimentos it was founded in 1981 by...
(BPI.LS) - RWERWERWE AG , is a German electric power and natural gas public utility company based in Essen. Through its various subsidiaries, the energy company contributes electricity and gas to more than 20 million electricity customers and 10 million gas customers, principally in Europe...
(RWE.DE) and E.ONE.ONE.ON AG, marketed with an interpunct as E•ON, is the holding company of the world's largest investor-owned energy service provider based in Düsseldorf, Germany. The name comes from the Greek word aeon which means eternity....
(EOAN.DE)
Model-based pairs trading
While it is commonly agreed that individual stock prices are difficult to forecast, there is evidence suggesting that it may be possible to forecast the price—the spread series—of certain stock portfolios. A common way to attempt this is by constructing the portfolio such that the spread series is a stationary processStationary process
In the mathematical sciences, a stationary process is a stochastic process whose joint probability distribution does not change when shifted in time or space...
. To achieve spread stationarity in the context of pairs trading, where the portfolios only consist of two stocks, one can attempt to find a cointegration
Cointegration
Cointegration is a statistical property of time series variables. Two or more time series are cointegrated if they share a common stochastic drift.-Introduction:...
relationship between the two stock price series. This would then allow for combining them into a portfolio with a stationary spread series. Regardless of how the portfolio is constructed, if the spread series is a stationary processes, then it can be modeled, and subsequently forecasted, using techniques of time series analysis. Among those suitable for pairs trading are Ornstein-Uhlenbeck models, autoregressive moving average (ARMA) models and (vector) error correction models. Forecastability of the portfolio spread series is useful for traders because:
- The spread can be directly traded by buying and selling the stocks in the portfolio, and
- The forecast and its error bounds (given by the model) yield an estimate of the return and risk associated with the trade.
According to a paper of B. Do, R. Faff and K. Hamza, the success of pairs trading depends heavily on the modeling and forecasting of the spread time series.
Market neutrality
- The pairs trade helps to hedge sector- and market-risk. For example, if the whole market crashes, and the two stocks plummet along with it, the trade should result in a gain on the short position and a negating loss on the long positionLong (finance)In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
, leaving the profit close to zero in spite of the large move. - Pairs trade is a mean-reverting strategy, betting that the prices will eventually revert to their historical trends.
- Pairs trade is a substantially self-funding strategy, since the short sale proceeds may be used to create the long position.
Algorithmic pairs trading
Today, pairs trading is often conducted using algorithmic trading strategiesAlgorithmic trading
In electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
on an Execution Management System
Execution management system
Execution management systems are software applications utilized by institutional traders designed to display market data and provide seamless access to trading destinations fast for the purpose of transacting orders. They contain broker provided and independent algorithms, global market data and...
. These strategies are typically built around models that define the spread based on historical data mining and analysis. The algorithm monitors for deviations in price, automatically buying and selling to capitalize on market inefficiencies. The advantage in terms of reaction time allows traders to take advantage of tighter spreads.