1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion

Pairs traders use 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 factors

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 aren’t limited to:

Technical factors

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:

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. (For more, see: Beta: Know the Risk.)
 
Deciding to implement a fundamental or technical approach is a matter of personal preference. Many pairs traders – particularly, 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. (See also: Understanding Fundamental Vs. Technical Analysis.)


Pairs Trade Example
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