Pair Trading Explained

Market neutral, pair-trading strategies allow traders to reap profit off stock markets regardless of directional forecasting. It embraces simple principles, though the reward does not come easily.

Basic Tenet

Some institutional traders consider Pair-Trading a type of statistical arbitrage (like this one). It first takes two stocks or ETFs of very high positive correlation, i.e. they basically move in concert, and when their prices deviate you short the high, long the low, and close both positions for a profit when (and if) their prices converge.

The fundamental steps entail importing historical prices into statistical software, and then enter when they diverge by 2-3 standard deviations, closing positions if and when prices converge later on.

Main Risks

No adequate exit strategy if the pair never converges. Remember Long Term Capital Investments run by those Black-Scholes Nobel Prize winners? They lost a fortune betting on a pair of oil based stocks.

Too much time may lapse before convergence. Naturally if it takes several years for a pair to converge, the loss in opportunity cost may become quite significant.

Potential volatility may cause margin issues with open positions. To effectively manage this, potential reward becomes lowered, an uncomfortable trade off.

Liquidity issues still stand, especially with short positions becoming potentially squeezed. Some could argue that having a pair highly negatively correlated may solve this issue, yet while working with large volumes, liquidity and price impact matters will not go away.

Profitable?

Yes it can be, but not via simply entering and exiting based on guesses. It takes meticulous planning and active execution. It will not generate all winners, but as long as you can provide yourself a statistical edge, it will work.