Pair trading Basics
The basic principle of Pair trading is to first identify two assets (it can be stocks, indices, commodities or forex) that show a historic good
correlation. Despite a good long term correlation sometimes this pricing makes on Asset A to be relatively cheap or expensive compared to Asset B. It can be certain news or just some buying or selling pressure in one of the assets causing the prices of A and B to diverge.
The most commonly traded strategy is "Revert to mean" which relies on the presumption that the prices of the two assets eventually will converge back to their mean and continue to follow the established historical good correlation.
So if Asset A becomes too cheap relative Asset B we enter a Long position in A and at the same time we establish an equally sized short position in B. Consequently if Asset A becomes to expensive relative Asset B we w enter a short position in Asset A and a long position in B. We now have a so called hedged position and it does ot matter if the general market goes up, down or sideways. For us the only important thing is that asset A develops relatively better than B. So even if both drop in value that is ok as long as B looses more in value than A. Please note that with equally sized position I refer to the same money value on both sides. So if you for instance are long 10.000 USD Asset A you should enter an equally sized 10.000 USD short position for Asset B.
Below you'll find the following two examples of successful Pair trades (also called Statistical Arbitrage).
The basic principle of Pair trading is to first identify two assets (it can be stocks, indices, commodities or forex) that show a historic good
correlation. Despite a good long term correlation sometimes this pricing makes on Asset A to be relatively cheap or expensive compared to Asset B. It can be certain news or just some buying or selling pressure in one of the assets causing the prices of A and B to diverge.
The most commonly traded strategy is "Revert to mean" which relies on the presumption that the prices of the two assets eventually will converge back to their mean and continue to follow the established historical good correlation.
So if Asset A becomes too cheap relative Asset B we enter a Long position in A and at the same time we establish an equally sized short position in B. Consequently if Asset A becomes to expensive relative Asset B we w enter a short position in Asset A and a long position in B. We now have a so called hedged position and it does ot matter if the general market goes up, down or sideways. For us the only important thing is that asset A develops relatively better than B. So even if both drop in value that is ok as long as B looses more in value than A. Please note that with equally sized position I refer to the same money value on both sides. So if you for instance are long 10.000 USD Asset A you should enter an equally sized 10.000 USD short position for Asset B.
Below you'll find the following two examples of successful Pair trades (also called Statistical Arbitrage).
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The graph below shows the stock prices for the two well known stocks GS=Goldman Sachs and C=Citigroup. As you can see in
this example we could have made two 2 trades each held for around 1 week and yielding 4% each. |
The graph below shows the indices futures price of the German DAX and the UK FTSE 100. As the example shows the two indices diverged and there was an opportunity to enter a long FTSE and short FTSE position for around 4 days yielding 3%.
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Click on picture to enlarge it
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Click on picture to enlarge it
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Pair trading strategies
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Advantages with Pair trading
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