Pairs traders employ either fundamental or technical analysis, or a combination of the two, to make decisions regarding which instruments to pair, and when to get in and out of trades. Many pairs traders apply technical analysis techniques and then confirm the findings using fundamentals. This extra “layer” of analysis can be used simply to ensure that the trade “makes sense”. For instance, if all technical analysis points to taking a long position in stock ABC and a short in XYZ, but the fundamentals show that stock ABC will have a weak earnings report, the position may need to be reconsidered.
Fundamental analysis examines related economic, financial and other qualitative and quantitative factors to evaluate a security’s value, and to determine which security will perform better in the short-term. Fundamental analysts may consider a number of growth and value factors when identifying opportunities for pairs trading. These include (but are not limited to):
- Changes in operating margins
- Discounted cash flow
- Dividend discount model
- Dividend yield
- Excess cash flow
- Price/earnings to growth (PEG ratio)
- Price-earnings ratio (P/E ratio)
- Price-to-book ratio (P/B ratio)
- Price-to-cash-flow ratio (price/cash)
- Price-to-sales ratio (price/sales)
- Return on equity
- Total assets over sales.
Technical analysis, on the other hand, is a method of evaluating securities by analyzing statistics generated by market activity; in particular, historical price and volume. Rather than attempting to measure a security’s intrinsic value, technical analysis seeks to identify patterns to predict future price movements.
Pairs traders call on a variety of tools and technical indicators to identify trading opportunities. The technical analyst may use, for example:
- Chart patterns (i.e., candlestick charting)
- Commercial indicators
- Moving averages
- On-balance volume (OBV)
- Relative strength index (RSI)
- Support and resistance
- Trend lines.
Other metrics may be useful to pairs traders as well. Consider beta, for example. Market risk can be measured by beta: a measure of a stock’s volatility relative to the market. The market has a beta of 1.0, and each individual stock is ranked based on how much it deviates from the market. If a stock swings more than the market over time, it will have a beta above 1.0; conversely, if a stock moves less than the market, its beta will be less than 1.0. High-beta stocks are considered riskier but tend to provide the potential for higher returns. Low-beta stocks have less risk, accompanied by lower potential returns. Ideally, the securities in a pairs trade have betas that are stable over time.
Deciding to implement a fundamental or technical approach is a matter of personal preference. Many pairs traders, and in particular short-term traders, prefer a technical approach. Some conduct technical analysis and look for confirmation using certain fundamentals, while others may use fundamental analysis exclusively. As with any investment strategy, finding the right combination of analysis tools and methodology takes research, historical modeling and testing.
Pairs Trade Example
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