A pair trade is the taking of a long position in one security together with an equal short position in another that is strongly correlated with it. It is sometimes used to refer to multiple long and short positions that are similarly matched.
1. Statistical Arbitrage
(Pair Trading)
A pair trade is the taking of a
long position in one security together
with an equal short position in
another that is strongly correlated
with it. It is sometimes used to
refer to multiple long and short
positions that are similarly matched.
2. The Elements of Pairs Trading
Overview
Pairs Trading is the synthesis of 3 basic elements:
:-The Market Neutral Element:
Market neutrality is central to pairs trading because it drives how trades are built and analyzed, it defines
relative risk metrics & it serves as the basis for the overall trading strategy .
:- The Arbitrage Element :
Arbitrage is central to pairs trading because it provides the framework for the success or failure of a
trade, and, therefore is the basis of absolute risk management
:- The Technical Analysis Element : Technical analysis is central to pairs trading because it provides
many of the tools by which a trader may make decisions about both the quality and the timing of any
potential trade
3. The Market Neutral Element
Many types of neutrality must be considered:
Sector or Industry Neutrality:
A pairs trade that crosses sector or industry lines may be statistically attractive, but each leg of the trade is
acted on by different market forces that may affect the ultimate success of the trade .
Market Capitalization Neutrality:
Pairing stocks with significantly different market caps may leave a trade vulnerable to regular market
rotations.
Beta Neutrality :
Pairing stocks with significantly different betas builds a market direction bet into a trade
where it may not be wanted. While total beta neutrality is very difficult, a pairs trader must
always be aware of the betas of the two stocks he or she is pairing
4. The Market Neutral Element
Share Neutrality vs. Dollar Neutrality:
Share Neutrality
The classic “spread” trade
Not really market-neutral
Creates situations of proper analysis while still losing money
Dollar Neutrality
Pure “pairs” trade
Assures proper analysis leads to profits
Example
Stock A - $10 Stock B - $5
Share Neutral Spread Dollar Neutral Pair
Long 1000 Shares A = $10,000 Long 1000 Shares A = $10,000
Short 1000 Shares B = $5000 Short 2000 Shares B = $10,000
5. Market Falls 20%, Stock A Outperforms
Stock A - $8.50 Stock B - $4
Long 1000 Shares A = $8,500 :
Short 1000 Shares B = $4000
Net = Loss of $500
Long 1000 Shares A = $8,500
Short 2000 Shares B = $8,000
Net = Profit of $500
6. The Trading Process
Model or Screening Tool
Technical
Analysis Market
Element Neutral
Element
Arbitrage
Fundamental / Technical Overlays
Element
Additional Statistical Filters
PAIRS PORTFOLIO
7. Hedge Funds
Hedge -- if something loses value, something else is to gain in
value, and vice versa.
A basic hedging strategy is pairs trading. Involves matching a
long position with a short position.
Funds use mathematics and statistics to identify pairs with good
spread reversion characteristics. Can be done with stocks,
options, commodities, currencies, etc
8. How Pairs Trading Works (a)
go short
75
go long
go long
go short
go short go long
70
go short
65 go long
9. How Pairs Trading Works (b)
liq,goshort
+500
75 -200 +7300
liq,golong liq
+7100
goshort liq,goshort liq,golong +800
+0 liq,golong
70 +700
+500 +500 liq,goshort
-6700
-300
-6500 +500
liq
65 golong +500
Based on historic observations: Mean spread 3.0 with stdev 1.6
. Go into action, say, when spread +d or -d stdevs.
Strategy can be optimised.
10. Product rationale
Aim to generate returns from a portfolio in an all-seasons environment
Reduce the “market risk (beta)” by investing in “stocks/derivatives with
pair trades”
Pair trades will illustrate our positive and negative convictions in stock
ideas
The fund would endeavor to attain market neutrality by means of
executing pair trades
Pair trades can be done on stocks and indices
Basic premise: Aims to “Generate returns” in all market conditions
An extension of our “active fund management” skills
Stock selection would generate the returns (alpha) of the fund
11. Trading & Investment strategies
Strategy A:
– Long stock (equity)
– Short stock futures
Strategy B:
– Long stock futures
– Short stock futures
Strategy C:
– Long stock (equity) / stock futures
– Short index futures
Strategy D:
– Long index futures
– Short stock / futures
Strategy E (possible due to stock lending, recently allowed by SEBI):
– Long stock
– Short stock
12. Investment philosophy: Portfolio returns
Situation A: Stock A – long stock futures; stock B – short stock futures
– Post trade, price of stock A goes up and post trade, price of stock B goes down
– This is a best case scenario, where such trades will result in profits in both the legs of the trade
resulting in profit
Situation B: Stock A – long stock futures; stock B – short stock futures
– Post trade, price of stock A goes up more than stock B
– Relative out performance of stock A compared with stock B
Situation C: Stock A – long stock futures; stock B – short stock futures
– Post trade, price of stock A goes down less than stock B
– Relative out performance of stock B compared with stock A
Situation D: Stock A – long stock futures; stock B – short stock futures
– Post trade, price of stock A goes down while stock B goes up (worst case scenario)
– Trade going the other way
13. The next four slides are for illustration purpose only
These are not stock recommendations
Examples of pair trade
14. Jspl vs. tata steel
Trade: Buy JSPL; Sell Tata Steel
Logic: While downcycle in steel would impact both the stocks, JSPL will likely be better off due to its
power business which has started contributing significantly to earnings and cash flows.
Returns: Approx. 4.5% absolute returns over a period of 11 days
15. Trade: Buy GVK; Sell GMR
Logic: Funds constraints faced by GMR and lack of avenues to raise funds will hamper many of their
projects. GVK has a lower debt and not in immediate need of funds. Also, relative valuation of GVK
better than GMR leading to expectation of relative out-performance.
Returns: Approx. 20% absolute returns in 12 days
16. Trade: Buy India Bulls Real Estate; Sell DLF
Logic: IBREL was trading close to cash on the books while DLF due to recent run up in a tough macro
environment was relatively expensive. However, we had to close the trade when DLF stock price shot up
on rumors of DLF having arranged funding for DAL (DLF Assets) which would have taken care of funding
constraints.
Returns: Approx. absolute (-) 5% returns in 5 days
17. Applying Pairs Techniques to Futures Trading
Analyzing Similar Commodity Types:
Futures with similar characteristics
Futures on Stock Indices
Energy Complex
Agricultural commodities
Interest Rate Futures
Precious Metals
Currencies
Futures with inverse relationships
Gold and the U.S. Dollar
Stock Index Futures and Interest Rate Future in Certain Economic Environments
Some Currencies