A Pairs trade is a type of convergence trade that attempts to capitalize on temporary divergences in prices or performance of highly correlated securities in a fairly riskless manner. The pairs trade is a unique trade, as it enables the trader to profit regardless of the direction of the market (up, down, sideways).
How to execute a pairs trade:
1.) Identify two securities with price performance that is highly correlated.
A good example of two such securities are Berkshire Hathaway A & B shares. By definition, class B shares are a fractional claim or class A shares so they should trade in perfect parity. As can be seen in the stock charts though, while they move in the same direction, they rise and fall at different points. Traders can profit off of these divergences in price.
2.) Monitor the selected securities for a divergence in price, as outlined above. Such divergence can occur because of temporary changes in the supply and demand of available shares, reactions to news about the security, large buy or sell orders for one security or the other and so on.
3.) When prices diverge, the trader “bets” that the spread will eventually converge by shorting the outperforming security (the one that has increased more) and goes long on the security that has not had proportional performance (the one that has increased less). This strategy produces some sort if gain should the over performing stock drop, the underperforming stock rise or any combination of the two. It is easy to see the required market timing skills to execute a pairs trade as the opportunity to profit is scarce. It is also easy to see how this strategy can be self funding, as the proceeds from the short sale can be used to cover the related long position.
What is the counter party risk in a pairs trade: Pairs trading inherently has counter party risk should multiple counterparties be used for the long and short position. For example, should the stock price increase and the short position requires a margin call but the long position counterparty defaults the trader will be left paying on a significant liability with no income to offset. A notable example of this can be seen in the collapse of Long Term Capital Management.
What is the timing risk in a pairs trade?: Should the spread not converge, or worse yet become wider, while the trader has the position open, the trader will lose money. The trade inherently is a bet on the convergence within a given time period.
What is the pricing risk in a pairs trade?: The pairs trade is by it's nature a mean-reverting trading strategy. That means that it relies on the assumption that prices will revert to historical trends, in this case a high level or correlation to another security. As such, if there are fundamental changes in the characteristics of the securities a future revert to the old price parity may not be likley.
What is the pricing risk in a pairs trade?: The pairs trade is by it's nature a mean-reverting trading strategy. That means that it relies on the assumption that prices will revert to historical trends, in this case a high level or correlation to another security. As such, if there are fundamental changes in the characteristics of the securities a future revert to the old price parity may not be likley.
What is the difficulty with a pairs trade?: There is a scarcity of opportunities to execute this trade, as the first one to notice it usually takes on positions that allow for profiting and forcing prices toward convergence.
Some Examples of Potentially Correlated Equities:
| ^DJI-Dow Jones | & | ^GSPC-S&P500 |
| KO-Coca-Cola | & | PEP-Pepsi |
| DELL-Dell | & | HPQ-Hewlett-Packard |
| XOM-Exxon Mobil | & | CVX-Chevron Corp |
| AL.L-Alliance and Leicester | & | RBS.L-Royal Bank of Scottland |
| PTC.LS-Portugal Telecom | & | TEF.MC-Telefonica |
| MBC.LS-Banco Comercial Português | & | BPI.LS-Banco Portugues de Investimento |
| BHP-BHP Billiton Limited | & | BBL-BHP Billiton plc |
For More Information Consider Checking Out: An Introduction to Trading In the Financial Markets
Categories:
Equities,
Finance_Principals,
How_To_Trade,
Intermediate,
Pairs_Trade,
Time