When it comes to investing, most people may follow the simple methodology of “buy low, sell high”.
This can be quite a problematic way to think about investments as it requires you to buy a stock when there’s a market crash and sell when the market is going up.
Normal psychology would have you being afraid to buy since prices are spiralling downwards and when the market is on the uptrend, you might want to hold on to the stock in case of more gains instead of selling it.
That’s where a trading strategy like pair trading can help.
Pair trading or any other market-neutral trading strategy gives investors the opportunity to make money in both bull and bear markets. However, it involves consistency, discipline and a clear mind in order to win at it – are you ready?
What’s Pair Trading?
Pair trading is a trading strategy that uses both short and long positions of two different stocks which are correlated simultaneously.
This is based on the theoretical concept that two stocks with close correlation will concur to convergent & divergent cycles.When divergence occurs, one stock gains in price and the other loses in value.
The trick here is to short the outperforming stock while buying the under-performing stock, in the hope that the spread between the two will converge and return to the “mean”.
The risk for an investor happens if the two stocks do not converge.
The strategy can be executed on various investment instruments, including stocks, options or futures. It is also not limited to just on a trading level; it can be on a portfolio basis as well.
Pair trading is a market-neutral investing, an investment strategy that seeks to neutralize certain market risks by taking offsetting long and short positions in an investment instrument.
These approaches seek to limit exposure to systemic changes in price caused by macroeconomic variables or market sentiment.
Let us show you how pair trading works with an example:
Say you would like to pair-trade two stocks in the banking sector – OCBC and DBS. Let us assume that the price of OCBC is not $7.50 and DBS is at $15, making their price ratio 1:2.
Since both are in the same sector, they are closely correlated (it’s advised to chart a correlation of their historical price to gauge their correlation coefficient). Correlations of 0.8 or above is a good benchmark to use for pair trades.
On a very basic level, if you think that the DBS stock price will fall and the OCBC price will rise due to certain announcements, you can buy 1 lot of DBS and sell 2 lots of OCBC shares.
Sell 1 lot of DBS – $15 x100 = $1,500
Buy 2 lots of OCBC – $7.50x 200 = $1,500
During the day, DBS price fell to $14.50, which OCBC has gained $0.30 to $7.80
Buy 1 lot of DBS – ($15-$14.50)X100 =$50
Sell 2 lots of OCBC – ($7.80-$7.50)X200 = $60
You would have made a profit of $110 (excluding fees).
Of course, since they are correlated, there is a possibility of OCBC’s share price falling as well. However, if the quantum of decline is less, you can still make a profit.
Let us assume OCBC price fell to $7.40. You would have made a loss of $20 on that trade, but still gain a net of $30 profit on the day.
In theory, pair-trading may sound easy but despite research and testing, a pair-trading strategy may fail to live up to expectations and pose certain risks that you should be aware of. We’ll discuss this in part II of this article.