Pair Trading

• The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy. The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s.

• The strategy monitors performance of two historically correlated securities eg Bajaj auto-hero honda. When the correlation 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.

• A profit situation arising from pricing inefficiencies between securities. Investors identify the arbitrage situation through mathematical modeling techniques.

• The strategy of matching a long position with a short position in two stocks of the same sector. This creates a hedge against the sector and the overall market that the two stocks are in. The hedge created is essentially a bet that you are placing on the two stocks; the stock you are long in versus the stock you are short in.
What makes Spread Trading such a profitable and easy way to trade?

• There is no stop when trading spreads. It is not possible to use stops in a spread trade. Because you are long in one market and short in another, you have become invisible to and immune to "stop fishing."

• Spreads can considerably reduces the risk in trading compared with straight futures trading. Every spread is a hedge. Trading the difference between two contracts in an intramarket spread results in much lower risk to the trader.

• Spreads on futures normally requires much lower margins than any other form of trading, even lower than the margin requirements for option trading. The result is much greater efficiency in the use of your capital. It is not unusual to be able to trade 10 spreads putting up the same amount of margin as required for 1 outright futures position.

• Spread trades are much less volatile than other forms of trading. They are considerably less volatile than share trading, option trading, or straight futures trading. In fact, it is because of such low volatility that margins for spreads are so low.

• Spreads typically trend more often, more steeply, and for a longer time than do other forms of trading. Since "the trend is your friend,"spread trading is friendlier. Spreads trend because of something real taking place in the underlying fundamentals. They are not moved by market makers and market movers, who push markets to run the stops.

• Spreads create a more level playing field. Because there are no stops possible, spread trading is a better form of trading.

To pair trade we have formulated the following indicators
- StdDev - the measurement standard deviation correlated pairs
- Spread - measurement difference is correlated pairs
- Stochastic - value for differences Stochastic Oscillator correlated pairs

Standard deviation:

We measure the standard deviation of price (close) of correlated pairs and the difference then is displayed as a curve. The price usually varies within certain limits, and these limits movement just counting. Once the price gets out, so it easily and close the sale of usable after returning to the mean . Ideal trade then means to enter somewhere at 2s. Indi implements the first entry before 2s and then according to the statistics less frequent values by percentiles (adjustable), mostly based on the value of 2.5s and 3.5s where already such a motion, at least.

Three Ways to Build a Pairs Trade

This article's topic is pairs trading -- a name which seems to imply two options working together toward a common goal, like the Williams sisters playing doubles tennis. However, a pairs trade is actually more accurately compared to a Cincinnati Bengals fan drafting the Pittsburgh Steelers' defense in her fantasy league: even if one option doesn't pan out as you hoped, the other option allows you to retain a shred of dignity. But, hey, enough about my failed playoff hopes. Let's take a look at three different ways you can hedge your bets with a pairs trade.

Long stock vs. short sector

At its essence, a pairs trade is simply two separate-yet-related option trades which are managed as a single position. Generally, we're talking about a bullish position paired with a bearish position. You can certainly buy a call on Apple (AAPL) and a call on the PowerShares QQQ Trust (QQQQ) and refer to it as a "pairs trade," but other option traders might look down on you. (Not me, of course.)

A pairs trading strategy is ideally suited to nearly any type of market environment -- up, down, sideways, and so forth. Since you gain both long and short exposure via one single position, there's no need to sweat the directional bias. However, I'm going to advise you not to force a pairs trade -- as you'll learn, there are situations when this strategy is not necessarily appropriate, depending upon your outlook.

One popular way of constructing your pair is by purchasing a long call on a particular stock, and then availing yourself of a long put on the sector of which that stock is a member. In other words, you are bullish on the stock, but bearish on the broader sector.

Obviously, this scenario will not always apply. This strategy usually works best if you have located a relative-strength leader in a lagging sector. For example, maybe the chip sector is suffering from a slowdown in corporate spending. However, the crafty minds at ABC Chips are dodging the slump, because they cleverly locked all of their major clients into binding multi-year purchase agreements. This is a prime pairs-trading setup for a long stock/short sector play.

Or, in a less fantastical scenario, let's assume that the chip sector is (still) suffering from a slowdown in corporate spending. However, ABC Chips cut costs drastically and swung to an unexpected second-quarter profit. The stock is soaring higher, and you see a lot of potential for the rally to continue -- but you're worried that macro-level concerns could work against you.

Enter the pairs trade. By purchasing a call on ABC Chips, and simultaneously buying a put on the chip sector (feel free to choose your favorite index or exchange-traded fund), you can capitalize on your bullish trading idea while simultaneously hedging against further weakness in the industry.

Needless to say, it's not necessarily true that you will always be bullish on the stock and skeptical of the sector. In these cases, please do not bother with a pairs trade. This tactic is best reserved for cases such as ABC Chips, where we have an outperforming stock swimming against the tide of its parent sector, much like a salmon flapping its way upstream.

Alternatively, you might have pinpointed a candidate for a bullish stock trade, but you've noticed that its broader sector (as represented by an index or ETF) is barreling into stubborn technical resistance on the charts, indicating that a potential pullback is on the horizon. This setup, too, virtually begs to be exploited by an opportunistic pairs trader.

In the best-of-all-possible-worlds scenario, the sector will continue to suffer as you expected, and ABC Chips will continue its stellar uptrend. If this happens, congratulations on being a statistical outlier! You're free to take profits as your trading strategy dictates.

However, it's quite possible that one leg of the trade will not play out ideally -- perhaps ABC Chips is dragged lower by bad news from a sector peer, or perhaps the broader sector is actually buoyed by ABC's strength. In any event, you must consider the pairs trade as a single entity before cutting losses or taking profits. If your ABC call is at a 75% gain and your corresponding sector put is at a 30% loss, remember that your pairs trade, as a whole, is still on positive ground. Calculate your return on the entire position before taking action to close out your call or put.

Because the two trades act as natural hedges for each other, the upside of pairs trading is that you could enjoy a greater win rate than you would by simply playing straightforward, un-paired directional trades. By extension, though, your "wins" will generally be smaller -- it's probably safe to assume you will not be raking in 1,000% returns on a pairs trade anytime soon, unless you're the aforementioned outlier.

Long sector vs. short stock

Of course, as the old expression goes, there's more than one way to build a pairs trade. You can also reverse the prior scenario in order to capitalize on your bullish expectations for a particular sector, while hedging your bets by shorting an underperforming stock within the group. (And when I say "shorting," I naturally mean "buying a long put.")

For example, let's say that crude oil is suddenly discovered to be a cure for the common cold. As such, you are wildly bullish on oil producers, and you're eager to buy a call on the sector. This would be a perfect straightforward speculative play, but for one thing -- you're concerned that the underperformance of Really Big Oil Co. could throw a wrench in your trade, due to a massive accounting scandal that's rocking the firm.

Whenever you're of two minds about a trading idea, as you hypothetically are in this situation, consider a pairs trade. By buying a call option on an exchange-traded fund (ETF) that tracks oil producers, you can take advantage of your bullish forecast for the group. Meanwhile, by simultaneously buying a put option on Really Big Oil, your overall position will be sheltered, in case the weakness in this titan of industry should negatively impact the ETF's performance.

The general idea here is the same as the previous scenario. You're simply capitalizing on your option trading ideas, whether bullish or bearish in nature, and then making an opposing bet on a related security in order to gain protection from potential threats to your initial position.

And that notion of "potential threats" is critical to the pairs trading philosophy. When I say not to force a pairs trade, I'm acknowledging that it's not uncommon to be, for example, bullish on a stock and bullish on the broader sector, as well. In other words, just because you buy a put on Wal-Mart Stores (WMT) doesn't mean that you must rush out and buy calls on a retail-based ETF. If you can't justify both legs of the position via solid fundamental, technical, and sentiment analysis, you probably shouldn't pull the trigger on that trade.

Long stock vs. short stock

Finally, there's no need to limit yourself to the stock/index or stock/ETF setup that we've been discussing up to this point. When I say "related securities," I mean any related securities. So, you could theoretically build a pairs trade by taking up a long option position on one regional bank, and simultaneously initiating a bearish trade on another regional bank.

The idea here remains the same: you're entering the trade with a single notion, either bullish or bearish. However, due to macroeconomic headwinds, concerns about the broader sector, or any other potentially negative catalyst, you feel the need to hedge your position with an offsetting trade.

By way of example, you think that Midwestern Savings & Loan is well-positioned to climb the charts, thanks to a recent capital infusion. However, you think that generally downbeat sentiment toward the sector could weigh heavily on your bullish position. So, in order to offset this possibility, you decide to snap up calls on Midwestern S&L, along with puts on Southeastern Trust -- a notable underperformer within the regional banking group.

Note that this is entirely different from a protective put strategy, wherein you purchase puts on a stock you hold to limit losses. (In fact, your losses are already limited, since you're trading long calls and puts.) Instead, this is a purely speculative play on two separate-yet-related stocks. By initiating the put position alongside the call, you're simply acknowledging that this is a scenario where outside factors could negatively impact your trade. Rather than just playing one leg of the position and hoping for the best, you decide to increase your chances of success by augmenting your trade with a natural hedge.

And that's the long and short of pairs trading, no pun intended. To read more on the topic, check out this in-depth commentary from none other than Bernie Schaeffer and Todd Salamone.