The Descriptive Guide to Pairs Trading
Introduction
Developed at Morgan Stanley in the late 1980s, under the wing of Nunzio Tartaglia and his crew, who later split out to form several of the world’s greatest hedge funds, particularly PDT Partners and D.E. Shaw (which then lead to Two Sigma) (which then lead to Two Sigma). Pairs trading has evolved to be a popular and sophisticated trading approach, with advanced MSc Financial Engineering programs frequently teaching it. Gerry Bamberger, the engineer who pioneered the approach and eventually left Morgan Stanley to join Ed Throp at Princeton Newport Partners, deserves special notice.
With the gradual advancement of markets and the development of technology, arbitrage opportunities have become increasingly scarce and the margins — smaller. To adapt to the market, the whole industry needed a makeover! In the early 2000s, the previously universally praised pairs trading technique entered its “ice age” and after over ten years, the rebirth of interest in the sector brought various sophisticated approaches, and with that — the much-needed shift.
The level of advanced scientific analysis amassed was exactly what was required for the strategy to mutate and reach its full potential as a truly universal and robust approach. The variety of methodologies range in complexity and choice of assets — this provides an altogether new stage for statistical arbitrage to emerge in the current financial sector.
What is Pairs Trading?
Pairs trading strategy is a clever non-directional strategy. As the name suggests, you take opposing long and short bets on a pair of highly correlated stocks. This approach is a non-directional strategy; it works not only when there are significant up-moves in the market but also in any market conditions.
The idea is to select a pair of stocks that have a strong correlation. We trade when the correlation between the two assets weakens. When one stock climbs up while the other moves down, one would sell the outperforming one and buy the underperforming one. The bet is that the “spread” between the two will converge.
“Pairs trading is a method that takes leverage of the mispricing between two or more co-moving assets, by holding a long position in one(many) and shorting the other(s), wagering that the relationship will hold and that prices will converge back to an equilibrium point”
Mathematics of Pairs Trading
While the principle behind pairs trading is basic, the mathematics behind the pairs trading technique is based on specific advanced statistical concepts like mean reversion and stationary stochastic processes.
Steps to develop a Pairs Trading Strategy
Pairs Selection: In a pairs selection step, our goal is to locate the co-moving assets to do so, we apply techniques like co-integration tests and distance metrics.
Spread Modelling: The next step is to construct the spread in a way that maximizes the mean reversion and ensures the market neutrality of the approach.
Trading Rules: Finally, the trading rules are developed depending on the type of exploited approach and the spread behavior
What are the upsides and downsides of Pairs Trade?
When a pairs trade works as plotted the investor profits; the investor is also able to reduce potential losses that would have occurred in the operation. Profits are earned when the underperforming security attains value, and the outperforming security’s price dampens. The net profit is the sum generated from the two positions.
There are various constraints for pairs trading. One is that the pairs trade depends on a high statistical correlation between two securities. Most pairs trades will need a correlation of 0.80, which might be tough to discover. Second, while historical trends can be correct, past prices are not always indicative of future developments. Assuming simply a correlation of 0.80 can likewise diminish the chance of the desired outcome.
Disclaimer: There are potential risks relating to trading and investing and you should not trade with money that you cannot afford to lose however, for those that educate themselves and adopt appropriate risk management strategies, the potential update can be significant. Please note that all opinions, research, analysis, and other information are provided as general market commentary and not as specific investment advice.
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