Thursday, December 13, 2012

What is Pair Trading and how to Pair trading works and Is Pair Trading right for you?

 What is Pair Trading?

Pair trading, also known as statistical arbitrage or spread trading, is a strategy that allows the trader to capture anomalies, relative strength or even fundamental differences on two stocks or baskets while maintaining a market neutral position. This powerful trading strategy once used only by large institutional investors and hedge funds has been adapted for implementation in your taxable trading accounts. Market neutrality has never been more important, as it allows the trader to capture profits in up, down, or sideways markets while giving you the freedom from having to predict the direction of the overall market.


The key to the strategy is simply finding correlated stocks (preferably NYSE mid and large capitalized stocks), exploiting the times when they diverge from their correlation, following simple rules of entry and exit, and having a disciplined money management system in place.

When pair trading, you’re usually trading two correlated stocks;  sell short one stock while simultaneously buying the other. You’ve then “hedged” yourself to the market and therefore the market is free to do what it wants. If the market goes down, your short position should make money. If it goes up, your long position should make money. Of course, while each side of your trade is making money, there’s the other side that is losing money. However, that’s the key to pairs…you can be in a pair while the market is moving quickly and your pair price can barely move 50 cents. Why is this beneficial? The pair helps curb the price action and increases the predictability of the action.

In other words, the pair of the two stocks creates tighter, more predictable ranges for the trader to trade. It’s then your job as the trader to wait for the time when one of the stocks jumps out of it’s normal correlation and play for the pair to come back to normal, or to occasionally trade toward the convergence.

Below is another example of the type of action that a spread gives you as it forms great support and resistance levels and develops a nice range.


 How to Pair trading works:

 Pair trading works by purchasing a stock and simultaneously selling short the stock of a second correlated so exciting couple of trade when relations between the two stocks has returned to its mean. It was a very active exchange by professional traders and hedge funds worldwide for decades.

We will give an example using coke stocks (ticker: KO) and PepsiCo (ticker: PEP). As you know, it is two very similar because they both operate in the same markets and sell the same products, soft drinks. For two KO and PEP are exposed to the same macroeconomic conditions and industry, their stock prices are measured at similar assessments of the market. That they will act with similar price / earnings and other valuation metrics. If you place a stock chart of KO, PEP and overlay on top, you will see that the two stock prices move in a very similar pattern over time.

From time to time, share prices that differ from each other. This is a pair trading opportunity, with the idea that buying and selling shares in the open reduced the population has increased, and the output once the relationship between populations correlated returns to normal. It is also known as mean reversion, statistical arbitrage, trading or market neutral long / short.

When you use a couple of trading, you must make sure that you do two similar stocks other examples of pairs of stocks are correlated Dell vs. IBM, Google and Yahoo and eBay vs. Amazon vs.. Ensure that commercial software shows you the relationship between the two corresponding populations are more than 70%, with a really good pair of over 90% correlation. Always having an equal share of your account in the long and short positions, this will keep your portfolio market-neutral, it is you are not exposed to fluctuations in the consumer market in ways that build on the relationship between the two Stocks correlation, not direct effect on the market, which is significantly reducing your risk and allows you to safely increase your negotiating leverage.

Since 1000 there is a store there for a couple of exchanges, it is impossible to calculate all the correlation values with the hand or spreadsheet, you will need a couple of trading software is to find the right equipment and pairs adds them to the checklist is to inform the trading signals. After downloading the list of titles for my pair of commercial software, it is therefore necessary to find the highest correlation between pairs of images of running back to the test. Once you find a list of pairs of stock for more than 70% agreement, add them to your watch, so it can inform trading signals, buy and sell stocks, wait a couple of returns to the average the signal.

Only you can answer this question. The PairTrader.com founders and many others like them have chosen this method of trading over traditional momentum based trading strategies for various reasons. Some investors may even use these techniques to profit from the differential between an overvalued stock and an undervalued stock while remaining for the most part market neutral. If you have been looking for answers inthese difficult and unpredictable market conditions read the personal experience of Rob.

Is Pair Trading right for you?

Rob Friesen's Experience:

I was introduced to the markets through a friend in the mid 80’s as he instructed me how to read the stock tables in the newspaper and showed me some of his gains made through investing. It wasn’t until 1993 that a different friend who now trades with Bright Trading in Langley, B.C. recommended that I get into a penny stock he had discovered. I had to open a retail account, funded it and then proceeded to buy the stock on a day that it had a fabulous news release. The stock went down and down and down some more. After losing half my money, I vowed to continue with this stock market thing until I found out what happened to my money.  At this point I hadn’t heard the adage “buy rumor, sell news” but was soon to learn that and more.

I continued to play around with penny stocks for a few years moving from a full service brokerage account to a discount broker. As I traded more frequently, the commissions were eating up any profits.  During this time I ran a number of businesses. I had a flow- through contract with the Municipality for the collection of recyclables, which I maintained for 8 years. I also started a communications company in Alberta, Canada and Washington State. I purchased a Bottled Water franchise that I expanded and resold. I also stabbed at other businesses and investments in search of the “perfect business”.

As I talked with family and friends about the businesses I was in, and also about stocks and trading I became aware of my career passion. Every time I had opportunity to chat about what I was experiencing and learning in the market, my eyes brightened and I felt alive. When In 1997 I discovered Bright Trading through their website: www.stocktrading.com.  I recognized an opportunity for a viable career and the type of business I had been searching for. I started with Bright Trading as an off-floor trader on January 10, 1998.

I struggled greatly in those first years, what could be called the greatest Bull market in history, as I wasn’t used to market volatility and to trading against so many professionals on very pricey and high beta stocks. I was trying to learn to read the tape and trade momentum, but became a chaser of the action. It wasn’t a great time to be learning in but would have been fantastic if one was skilled prior to the bubble.

On August 10, 1998 I opened the Seattle Downtown office for Bright Trading and proceeded to work with many new traders who came from regular jobs and businesses, not from the industry. I enjoyed working with very new traders as they were teachable, and simply passed on the things I was learning. Unfortunately for many of them, the momentum strategy was hard to learn and presented great risk, as they were naked in the market without a hedging instrument. I spent 1-½ years in Seattle before it was time to bring that season to a close and spend more time with my family. I had been commuting 2 ½ -3 hours, and most of the time staying in Seattle during the week and coming back to my home in Langley, BC for the weekends. It was a hard 1-½ years with much sacrifice. I pressed on, as I believe that if a person does what they love, they will find fulfillment and the money will come.

In January of 2000, I started trading out of my home in Langley. BC and by June had 4 traders in my 650 sq ft. garage that I had renovated. By November of that year I had 8 traders and a receptionist in my garage. By Christmas of that year I opened an 1850 sq ft office in Langley, near my home. The decision I had made before undertaking the building of another office after Seattle was that I was going to do everything in my power to assist new traders with an appropriate trading model, I'd try to retain them and also help them be profitable. It was because of this desire that I undertook learning how to spread trade. This was a strategy that I had heard about that allowed the trader to be market neutral, which I could see as a big help to assisting the newer trader in not feeling vulnerable and exposed to the volatility of the market. I proceeded to learn it and teach it to my traders in a grass roots developing office in my garage.

The results were fantastic and better than I could have hoped as people completely unfamiliar with the markets grasped the techniques, and ground out consistent profits daily. This was exactly what was needed as these guys left regular jobs and needed to pull a paycheck from the market. My first focus was on Risk Arbitrage (Mergers), then adding Statistical Arbitrage (Pairs) in February of 2001. My first outside student had his trading career restored and revitalized when he came to Langley for mentoring in September 2000. That started a stampede of momentum traders looking for help as their game had changed and the need for new strategies was urgent. Since that time I have trained over 65 traders. Many of them are doing well and some have become the best performing traders in their respective offices. Steve Slavin came to me in for training in October 2001 and in April 2002 we decided to join forces in developing tools, educating and assisting traders.

Please enjoy what our combined experience and work has produced for you in this training manual and do not hesitate to benefit from the other tools such as the website and software that we have developed for you. Please note that all these tools were originally developed for the spread traders in the Langley Bright Trading office and were necessary, as they did not exist in the trading community. As traders came to the Langley office for mentoring, they asked how they might get tools for themselves. We proceeded to convert all of our internal data to the web that now can be accessed by anyone with access to the Internet. A users manual was written for the software and all processes streamlined for customer convenience.

I struggled greatly in those first years, what could be called the greatest Bull market in history, as I wasn’t used to market volatility and to trading against so many professionals on very pricey and high beta stocks. I was trying to learn to read the tape and trade momentum, but became a chaser of the action. It wasn’t a great time to be learning in but would have been fantastic if one was skilled prior to the bubble.

On August 10, 1998 I opened the Seattle Downtown office for Bright Trading and proceeded to work with many new traders who came from regular jobs and businesses, not from the industry. I enjoyed working with very new traders as they were teachable, and simply passed on the things I was learning. Unfortunately for many of them, the momentum strategy was hard to learn and presented great risk, as they were naked in the market without a hedging instrument. I spent 1-½ years in Seattle before it was time to bring that season to a close and spend more time with my family. I had been commuting 2 ½ -3 hours, and most of the time staying in Seattle during the week and coming back to my home in Langley, BC for the weekends. It was a hard 1-½ years with much sacrifice. I pressed on, as I believe that if a person does what they love, they will find fulfillment and the money will come.

In January of 2000, I started trading out of my home in Langley. BC and by June had 4 traders in my 650 sq ft. garage that I had renovated. By November of that year I had 8 traders and a receptionist in my garage. By Christmas of that year I opened an 1850 sq ft office in Langley, near my home. The decision I had made before undertaking the building of another office after Seattle was that I was going to do everything in my power to assist new traders with an appropriate trading model, I'd try to retain them and also help them be profitable. It was because of this desire that I undertook learning how to spread trade. This was a strategy that I had heard about that allowed the trader to be market neutral, which I could see as a big help to assisting the newer trader in not feeling vulnerable and exposed to the volatility of the market. I proceeded to learn it and teach it to my traders in a grass roots developing office in my garage.

The results were fantastic and better than I could have hoped as people completely unfamiliar with the markets grasped the techniques, and ground out consistent profits daily. This was exactly what was needed as these guys left regular jobs and needed to pull a paycheck from the market. My first focus was on Risk Arbitrage (Mergers), then adding Statistical Arbitrage (Pairs) in February of 2001. My first outside student had his trading career restored and revitalized when he came to Langley for mentoring in September 2000. That started a stampede of momentum traders looking for help as their game had changed and the need for new strategies was urgent. Since that time I have trained over 65 traders. Many of them are doing well and some have become the best performing traders in their respective offices. Steve Slavin came to me in for training in October 2001 and in April 2002 we decided to join forces in developing tools, educating and assisting traders.

Please enjoy what our combined experience and work has produced for you in this training manual and do not hesitate to benefit from the other tools such as the website and software that we have developed for you. Please note that all these tools were originally developed for the spread traders in the Langley Bright Trading office and were necessary, as they did not exist in the trading community. As traders came to the Langley office for mentoring, they asked how they might get tools for themselves. We proceeded to convert all of our internal data to the web that now can be accessed by anyone with access to the Internet. A users manual was written for the software and all processes streamlined for customer convenience.