Pair trading, also known as statistical arbitrage or spread trading, is a strategy that allows the trader to capture anomalies, relative strength or even fundamental differences on two stocks or baskets while maintaining a market neutral position. This powerful trading strategy once used only by large institutional investors and hedge funds has been adapted for implementation in your taxable trading accounts. Market neutrality has never been more important, as it allows the trader to capture profits in up, down, or sideways markets while giving you the freedom from having to predict the direction of the overall market.
The key to the strategy is simply finding correlated stocks (preferably NYSE mid and large capitalized stocks), exploiting the times when they diverge from their correlation, following simple rules of entry and exit, and having a disciplined money management system in place.
When pair trading, you’re usually trading two correlated stocks; sell short one stock while simultaneously buying the other. You’ve then “hedged” yourself to the market and therefore the market is free to do what it wants. If the market goes down, your short position should make money. If it goes up, your long position should make money. Of course, while each side of your trade is making money, there’s the other side that is losing money. However, that’s the key to pairs…you can be in a pair while the market is moving quickly and your pair price can barely move 50 cents. Why is this beneficial? The pair helps curb the price action and increases the predictability of the action.
In other words, the pair of the two stocks creates tighter, more predictable ranges for the trader to trade. It’s then your job as the trader to wait for the time when one of the stocks jumps out of it’s normal correlation and play for the pair to come back to normal, or to occasionally trade toward the convergence.
Let us emphasize a key difference with pairs: you’re not trading the individual stocks based on their direction, but rather trading the difference between the two stock prices. This is called trading the differential and you’ll quickly learn that this key difference makes this type of strategy very different from other trading methodologies. In pair trading you’ll move away from the dependency of following the market’s direction and instead focus on trading the chart of the difference of the two correlated stocks.
The following charts are one great example of the advantage of a spread.
This is a chart of Citigroup by itself in the year 2002.
This is a chart of JP Morgan by itself in the year 2002.
And this is a chart of C minus JPM (the C/JPM pair chart) in the year 2002.
What do you see that strikes you as different? First off, both of the individual stocks have sold off sharply – both more than 20 points. If you’re on that trend to the downside it’s likely you made some good money, but we know it wasn’t easy doing so – likely fighting it all the way.
What else? The pair of C/JPM was kept to a 9-point range over the same time frame under the same market conditions. For many months the range was kept to 3 or 4 points — that’s it. Two stocks running wild, yet the correlation stayed intact. This is just one example of many.
[Note: Because you’re short selling a stock, you must have a margin account, and you can’t do this type of strategy in an IRA or non-taxable investment.]
Below is another example of the type of action that a spread gives you as it forms great support and resistance levels and develops a nice range.