As with nearly any investment, taking a pairs trade involves more than just hitting the buy and sell button. Here we examine, in very broad terms, the steps required to enter and exit a pairs trade.
Assemble a list of potentially related pairs
Just as long-only stock traders scan the markets for suitable securities, a pairs trader must start with a list of potentially related pairs. This entails conducting research to find securities that have something in common – whether the relationship is due to sector (such as the auto sector) or to asset (for example, bonds). While any random pair could theoretically be correlated, it is more likely that we will find correlation in securities that have something in common to begin with.
Determining the correlation level
The next step acts as a filter, or a means by which we can reduce the number of potential pairs in our quiver. One way is to use a correlation coefficient to determine how closely two instruments are related. Figure 4 shows a daily chart of the e-mini S&P 500 contract (in red) and the e-mini Dow contract (in green). Below the price chart is an indicator that shows the correlation coefficient (in yellow). We can see from the chart that during the time period evaluated, the ES and YM are highly correlated, with values hovering around 0.9. We will keep the ES/YM pair on our list of potential pairs candidates.
Figure 4 The e-mini S&P 500 contract (in red) and the e-mini Dow (in green) show potential as a pairs trade. Visual confirmation of price, backed by quantitative results from the correlation coefficient (in yellow), show that the two instruments are highly correlated. Image created with TradeStation.
Another chart, shown in Figure 5, illustrates a pair that is not correlated. In this example, a daily chart of Wal-mart (in red) and Target (in green) shows little correlation between the two instruments, despite the fact that they “have something in common”. Here, the correlation coefficient (in yellow) demonstrates that the relationship is scattered, ranging from high values of about 0.7 to values below zero, indicating a lack of correlation. In this case, we can remove the WMT/TGT pair from our list of potential pairs candidates.
Figure 5 This daily chart of WMT (in red) and TGT (in green) shows that this is not an ideal pair (at least not during the time period tested). A visual review of prices, confirmed by results from the correlation coefficient (in yellow) indicate a lack of correlation between the two stocks. Image created with TradeStation.
Use modeling to determine specific rules
An ongoing component of the process is to research and test trading ideas and determine absolute methods of evaluating pairs and defining divergence. Traders will have to answer questions like What constitutes “enough” divergence from the trend to initiate a trade? and How will this be evaluated (for example, using data from a price ratio indicator with standard deviation overlays). In general, traders should focus on quantifiable data: i.e., “I will enter a pairs trade when price ratio exceeds two standard deviations.” Figure 6 shows two ETFs – SPY (in red) and DIA (in green) – on a daily chart. Below the price chart is a spread ratio indicator (in blue), with a +/- one and two standard deviation overlay (dotted lines). The mean appears in pink.
Figure 6 A daily chart of the ETFs SPY (in red) and DIA (in green). A spread ratio indicator appears below the price chart, along with a standard deviation overlay. Image created with TradeStation.
Determining position sizing
Many traders use a dollar-neutral approach to position sizing when trading pairs. Using this method, the long and short sides of the trade are entered with equal dollar amounts. For example, a trader wants to enter a pairs trade with stock A, trading at $100 per share, and stock B, trading at $50 per share. To achieve a dollar-neutral position, the trader will have to purchase two shares of stock B for every one share of stock A. For example:
- Long 100 shares of stock A = $10,000; and
- Short 200 shares of stock B = $10,000.
Buy the underperformer and sell the overperformer
Once the trading rules are met, the trader will buy the underperforming security and simultaneously sell the overperforming security. In Figure 7, the spread ratio has exceeded two standard deviations, and a trading setup has occurred in our ES/YM pair. Here, a long position is entered with two ES contracts, and a simultaneous short position of two contracts is taken in the YM.
Figure 7 A trade is opened in the ES/YM pair. The order entry interface appears on the left side of the screen (one order entry box for the ES; one for the YM). The horizontal red and green lines at the top show the real-time P/L for each position. Image created with TradeStation.
Use sound money management principles to exit the trade
As with most investments, the timing of the exit is critical to the success of the trade. It is important to apply money management principles to pairs trades, including the use of protective stop-loss orders and profit targets. Optimal levels are typically determined through extensive historical modeling. Figure 8 shows the ES/YM trade, exited using a conservative net profit level.
Figure 8 The ES/YM trade is exited with a small net profit. Image created with TradeStation.
Despite exhaustive research, modeling and testing, a pairs trading strategy may fail to live up to expectations. Two risks that traders have are model risk and execution risk, introduced in the next section.
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