Find suitable Pairs to trade
To find suitable Pairs is absolutely crucial for a successful Pair trade. In this aspect there are many different theories regarding what to look for. There is of course normal correlation which shows how well to assets move in the same direction. Then there is cointegration which shows to what extent two assets revert to their mean. And finally you very advanced algorithmic formulas developed by math experts so called "Quants" at specialised brokerage firms and funds.
I have during the last 2 years developed my own style when I look for suitable pairs and will describe this below.
I have during the last 2 years developed my own style when I look for suitable pairs and will describe this below.
Calculate the Ratio also called Indexfactor
I like to view the Pairs I trade as new combined asset rather than as two separate assets. I feel that it is much easier to determine if it's a good Pair or not. Calculating the Ratio is simply done by dividing the Price of Asset A / Price of Asset B. For instance if the German DAX is priced at 6910 and the Swedish OMX is priced at 1356 I simply divide DAX/OMX = 6910/1356 = 7.16.
I like to view the Pairs I trade as new combined asset rather than as two separate assets. I feel that it is much easier to determine if it's a good Pair or not. Calculating the Ratio is simply done by dividing the Price of Asset A / Price of Asset B. For instance if the German DAX is priced at 6910 and the Swedish OMX is priced at 1356 I simply divide DAX/OMX = 6910/1356 = 7.16.
Look for Pairs with good long term correlation but high divergence on an daily basis
Theoretically the best pair to trade would be Pair where the Ratio had a mean value (20 day average) that looked like a horizontal line and the daily Ratio going up and down around this mean. Below you see an example where Asset A is priced at 200 and Asset B at 100.
Theoretically the best pair to trade would be Pair where the Ratio had a mean value (20 day average) that looked like a horizontal line and the daily Ratio going up and down around this mean. Below you see an example where Asset A is priced at 200 and Asset B at 100.
Click on picture to enlarge
As you can see the Pair Ratio swings between 1.98 and 2.02 resulting in a average of 2.00. I would SELL the Ratio meaning Go short Asset A and go long Asset B when the Ratio hits 2.02. I would then BUY the Ratio meaning Go long Asset A and short Asset B when the Ratio hits 1.98. For each full swing we would make a full 4% return.
Unfortunately these kind of picture perfect Pairs do not exist in the real world But I think it serves as a good example so that you know what kind of characteristics I'm looking for in an ideal Pair.
Unfortunately these kind of picture perfect Pairs do not exist in the real world But I think it serves as a good example so that you know what kind of characteristics I'm looking for in an ideal Pair.
Find and evaluate Pairs
When I want to make a new evaluation on if a Pair is suitable for trading I usually start with looking at them in either Yahoo Finance or Stockcharts. At Yahoo you get the traditional comparison with each asset having their own graph.
With Stockcharts you can actually plot the Ratio as a complete own Asset and even get it in a Candlestick chart. Simply enter the two Assets you want to look at like this GS:C. Then you can see this as if it where a single Asset. This is very convenient for finding suitable support and resistance areas to Pair trade from.
When I want to make a new evaluation on if a Pair is suitable for trading I usually start with looking at them in either Yahoo Finance or Stockcharts. At Yahoo you get the traditional comparison with each asset having their own graph.
With Stockcharts you can actually plot the Ratio as a complete own Asset and even get it in a Candlestick chart. Simply enter the two Assets you want to look at like this GS:C. Then you can see this as if it where a single Asset. This is very convenient for finding suitable support and resistance areas to Pair trade from.
Click on picture to enlarge
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Click on picture to enlarge
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Advantages with Pair trading
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Pair trading setups
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