Paired trading is about taking a long (bullish) position in one stock while simultaneously taking a short (bearish) position in another. The objective is to profit on the change in relative difference between the two stocks. It’s a simple concept but one that can be difficult to implement if you don’t find the right pair of stocks to go long and short.
The key to pair trading is to understand the nature of the two stocks you choose to pair. Ideally you want to find one stock that is relatively cheaper or more expensive than the other. You then choose to go long on the cheap stock and short on the expensive stock. Problem is, we don’t live in an ideal world and trying to determine what is cheap or expensive relative to one another is difficult at best.
Aussie Dollar vs Dow Jones
A more intuitive approach is to examine the historical difference, or spread, between the two stocks. You want to see if they correlate with one another. That is, you look to see if they tend to move with each other over time. This relationship is key, as there may be patterns in the spread that you can exploit.
For example; if the spread tends to fluctuate back and forth around an average number, then you can say that there is a divergence, and soon they will come together, or revert to the mean. If this happens consistently, over long periods of time, then you can be reasonably certain that this pattern will continue and exploit that behavior.
So, let’s say that you found over time that the average difference between two stocks is $1.00, and let’s suppose that the current price of one stock is $25, while the other is $30, then the current spread is $5. That’s $4 over the average spread. So, you could infer that one of the stocks is overpriced, while the other is under-priced, and that they will eventually revert to their mean of a $1 spread. The trade is to go long on the under-priced stock and short on the overpriced stock. Your target profit is $4.
Picking stock pairs is very difficult. It’s much easier to pick indexes to pair, like the S&P vs the Nasdaq, because they tend to move with each other in a similar manner over a long period of time.
There are two factors you should examine between stocks, beta and correlation. Beta measures the magnitude of the relationship. So if stock A has a beta of 2.00 and stock B has a beta of 1,00, this means that when one stock B moves up 1%, stock A moves up 2%.
A Correlation is a statistical coefficient that measures the strength of the relationship, it ranges between +1 and -1. A positive 1 (+1) means that when one stock moves up, the other moves down. A minus 1 (-1) means they tend to move up and down together. A zero (0) means they move without regard to one another.
Beta is used to determine how many shares of one stock to purchase relative to the other stock. So in the example above you need to purchase twice as many shares of one stock B to make sure there’s an equal risk to reward potential. Finding betas near 1.0 makes the position size easy because you would buy an equal number of shares to get the same risk to reward profile.
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