A pairs trade or pair trading is a
market neutral An investment strategy or portfolio is considered market-neutral if it seeks to avoid some form of market risk entirely, typically by hedging. To evaluate market-neutrality requires specifying the risk to avoid. For example, convertible arbitrage a ...
trading strategy
In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency ...
enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a
statistical arbitrage In finance, statistical arbitrage (often abbreviated as ''Stat Arb'' or ''StatArb'') is a class of short-term financial trading strategies that employ mean reversion models involving broadly diversified portfolios of securities (hundreds to thousan ...
and
convergence trading strategy. Pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia's quantitative group at
Morgan Stanley
Morgan Stanley is an American multinational investment management and financial services company headquartered at 1585 Broadway in Midtown Manhattan, New York City. With offices in more than 41 countries and more than 75,000 employees, the fir ...
in the 1980s.
The strategy monitors performance of two historically correlated securities. When the
correlation
In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistics ...
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 is the strategy of making buying or selling decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from ...
, and decision making skill. Although the strategy does not have much
downside risk
Downside risk is the financial risk associated with losses. That is, it is the risk of the actual return being below the expected return, or the uncertainty about the magnitude of that difference.
Risk measures typically quantify the downside ris ...
, 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; see
Dual-listed companies
A dual-listed company or DLC is a corporate structure in which two corporations function as a single operating business through a legal equalization agreement, but retain separate legal identities and stock exchange listings. Virtually all DLCs ...
.
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 process
In mathematics and statistics, a stationary process (or a strict/strictly stationary process or strong/strongly stationary process) is a stochastic process whose unconditional joint probability distribution does not change when shifted in time. Con ...
. 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 is a statistical property of a collection of time series variables. First, all of the series must be integrated of order ''d'' (see Order of integration). Next, if a linear combination of this collection is integrated of order less ...
irregularities between the two stock price series who generally show stationary correlation. This irregularity is assumed to be bridged soon and forecasts are made in the opposite nature of the irregularity. This would then allow for combining them into a portfolio with a stationary spread series.
[A. D. Schmidt: "Pairs Trading - A Cointegration Approach". University of Sydney, 2008. http://ses.library.usyd.edu.au/bitstream/2123/4072/1/Thesis_Schmidt.pdf] Regardless of how the portfolio is constructed, if the spread series is a stationary processes, then it can be modeled, and subsequently forecast, using techniques of
time series analysis
In mathematics
Mathematics is an area of knowledge that includes the topics of numbers, formulas and related structures, shapes and the spaces in which they are contained, and quantities and their changes. These topics are represented in m ...
. Among those suitable for pairs trading are
Ornstein-Uhlenbeck models,
autoregressive moving average
In statistics, econometrics and signal processing, an autoregressive (AR) model is a representation of a type of random process; as such, it is used to describe certain time-varying processes in nature, economics, etc. The autoregressive model spe ...
(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.
The success of pairs trading depends heavily on the modeling and forecasting of the spread time series. Comprehensive empirical studies on pairs trading have investigated its profitability over the long-term in the US market using the distance method, co-integration, and copulas. They have found that the distance and co-integration methods result in significant alphas and similar performance, but their profits have decreased over time. Copula pairs trading strategies result in more stable but smaller profits.
Algorithmic pairs trading
Today, pairs trading is often conducted using
algorithmic trading strategies on an
execution management system An Execution management system, or EMS, is an application utilized by traders designed to display market data and provide seamless and fast access to trading destinations for the purpose of transacting orders. This application contains broker provi ...
. 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 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
In finance, being short in an asset means investing in such a way that the investor will profit if the value of the asset falls. This is the opposite of a more conventional "long" position, where the investor will profit if the value of the ...
and a negating loss on the
long position
In finance, a long Position (finance), position in a financial instrument means the holder of the position owns a positive amount of the instrument. The holder of the position has the expectation that the financial instrument will increase in valu ...
, 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.
Drift and risk management
Trading pairs is not a risk-free strategy. The difficulty comes when prices of the two securities begin to drift apart, i.e. the spread begins to trend instead of reverting to the original mean. Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setup—a bet for reversion to the mean—has been invalidated. This can be achieved, for example, by forecasting the spread and exiting at forecast error bounds. A common way to model, and forecast, the spread for risk management purposes is by using
autoregressive moving average
In statistics, econometrics and signal processing, an autoregressive (AR) model is a representation of a type of random process; as such, it is used to describe certain time-varying processes in nature, economics, etc. The autoregressive model spe ...
models.
Some other risks include:
*In ‘market-neutral’ strategies, you are assuming that the
CAPM CAPM may refer to:
* Capital asset pricing model, a fundamental model in finance
* Certified Associate in Project Management, an entry-level credential for project managers
{{Disambig ...
model is valid and that beta is a correct estimate of
systematic risk
In finance and economics, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggreg ...
—if this is not the case, your hedge may not properly protect you in the event of a shift in the markets. Note there are other theories on how to estimate market risk—such as the Fama-French Factors.
*Measures of market risk, such as
beta
Beta (, ; uppercase , lowercase , or cursive ; grc, βῆτα, bē̂ta or ell, βήτα, víta) is the second letter of the Greek alphabet. In the system of Greek numerals, it has a value of 2. In Modern Greek, it represents the voiced labiod ...
, are historical and could be very different in the future than they have been in the past.
*If you are implementing a mean reversion strategy, you are assuming that the mean will remain the same in the future as it has been in the past. When the means change, it is sometimes referred to as ‘drift’.
A simplified example
Pepsi (PEP) and Coca-Cola (KO) are different companies that create a similar product, soda pop. Historically, the two companies have shared similar dips and highs, depending on the soda pop market. If the price of Coca-Cola were to go up a significant amount while Pepsi stayed the same, a pairs trader would buy Pepsi stock and sell Coca-Cola stock, assuming that the two companies would later return to their historical balance point. If the price of Pepsi rose to close that gap in price, the trader would make money on the Pepsi stock, while if the price of Coca-Cola fell, they would make money on having shorted the Coca-Cola stock.
The reason for the deviated stock to come back to original value is itself an assumption. It is assumed that the pair will have similar business performance as in the past during the holding period of the stock.
Examples of potentially correlated pairs
*
Coca-Cola
Coca-Cola, or Coke, is a carbonated soft drink manufactured by the Coca-Cola Company. Originally marketed as a temperance drink and intended as a patent medicine, it was invented in the late 19th century by John Stith Pemberton in Atlanta ...
(KO) and
Pepsi
Pepsi is a carbonated soft drink manufactured by PepsiCo. Originally created and developed in 1893 by Caleb Bradham and introduced as Brad's Drink, it was renamed as Pepsi-Cola in 1898, and then shortened to Pepsi in 1961.
History
Pepsi was ...
(PEP)
*
Domino's Pizza
Domino's Pizza, Inc., trading as Domino's, is an American multinational pizza restaurant chain founded in 1960 and led by CEO Russell Weiner. The corporation is Delaware domiciled and headquartered at the Domino's Farms Office Park in Ann Arbor ...
(DPZ) and
Papa John's Pizza
Papa John's International, Inc., d/b/a Papa Johns, is an American pizza restaurant chain. It is the fourth largest pizza delivery restaurant chain in the United States, with headquarters in Louisville, Kentucky and Atlanta, Georgia metropolita ...
(PZZA)
*
Renault
Groupe Renault ( , , , also known as the Renault Group in English; legally Renault S.A.) is a French multinational automobile manufacturer established in 1899. The company produces a range of cars and vans, and in the past has manufactured ...
(RNL) and
PSA Peugeot Citroen
The PSA Group (), legally known as Peugeot S.A. (Peugeot Société Anonyme, trading as Groupe PSA; formerly known as PSA Peugeot Citroën from 1991 to 2016) was a French multinational automotive manufacturing company which produced automobiles ...
(UG)
*
Wal-Mart
Walmart Inc. (; formerly Wal-Mart Stores, Inc.) is an American multinational retail corporation that operates a chain of hypermarkets (also called supercenters), discount department stores, and grocery stores from the United States, headquarter ...
(WMT) and
Target Corporation
Target Corporation (doing business as Target and stylized in all lowercase since 2018) is an American big box department store chain headquartered in Minneapolis, Minnesota. It is the seventh largest retailer in the United States, and a compon ...
(TGT)
*
Exxon Mobil (XOM) and
Chevron Corporation
Chevron Corporation is an American multinational energy corporation. The second-largest direct descendant of Standard Oil, and originally known as the Standard Oil Company of California (shortened to Socal or CalSo), it is headquartered in S ...
(CVX)
*
Portugal Telecom
Altice Portugal (formerly known as Portugal Telecom or PT) is the largest telecommunications service provider in Portugal. Since June 2, 2015, the company has been a wholly owned subsidiary of Altice Europe, a multinational cable and telecommuni ...
(PTC.LS) and
Telefonica (TEF.MC)
*
Banco Comercial Português
Portuguese Commercial Bank ( pt, Banco Comercial Português, BCP) 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 offic ...
(MBC.LS) and
Banco Português de Investimento
Banco Português de Investimento (BPI, ) is a major privately owned bank in Portugal owned by Spanish bank CaixaBank. It runs the banking business with companies, institutional and private clients. As ''Sociedade Portuguesa de Investimentos'' it ...
(BPI.LS)
*
RWE
RWE AG is a German multinational energy company headquartered in Essen. It generates and trades electricity in Asia-Pacific, Europe and the United States. The company is Europe's most climate threatening Company, the world's number two in offsh ...
(RWE.DE) and
E.ON (EOAN.DE)
*
BHP
BHP Group Limited (formerly known as BHP Billiton) is an Australian multinational mining, metals, natural gas petroleum public company that is headquartered in Melbourne, Victoria, Australia.
The Broken Hill Proprietary Company was founded ...
Billiton Limited (BHP) and BHP Billiton plc (BBL)
*
Coinbase
Coinbase Global, Inc., branded Coinbase, is an American publicly traded company that operates a cryptocurrency exchange platform. Coinbase is a distributed company; all employees operate via remote work and the company lacks a physical headq ...
(COIN) and
Bitcoin
Bitcoin ( abbreviation: BTC; sign: ₿) is a decentralized digital currency that can be transferred on the peer-to-peer bitcoin network. Bitcoin transactions are verified by network nodes through cryptography and recorded in a public distr ...
(XBT)
See also
*
Convergence trade Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future (going ''long'' the asset)—and selling a similar asset forward (going '' short'' the asset) for a higher price, in the ex ...
References
{{stock market
Investment
Arbitrage
pt:Long & Short
ru:Парный трейдинг