In part 1 of this article, we introduced the idea of pair-trading as a way for investors to find money-making opportunities regardless of which way the market is going.
Essentially, it is a market-neutral strategy that limits your exposure to systemic changes in price caused by macroeconomic variables or market sentiment.
Before you embark on using this strategy, you might want to note the risks involved.
1) Mean Reversion
Pair trading works on the premise of mean reversion – that the two stocks will converge based on historical data and probability. As we all know, past history is not always the best gauge of what may happen in the future.
In times where there is a significant change to one of the stock’s fundamentals, the mean-reverting relationship may change.
2) Market Neutrality
The idea of pair-trading as a market neutral strategy works only if the two stocks you chose are perfectly matched in terms of their price ratio. In reality, this might be difficult to execute.
In our initial example, we used the ratio of 1:2, but imagine if the price of the two stocks are $1.50 and $1.80 respectively, how do you allocate your buying of shares to reflect the price ratio?
On top of this, if you are using other investment class other than stocks to execute this strategy, it adds another layer of calculation due to the different “lot-size” used by these instruments.
So let’s assume you’ve got your price ratio perfectly right and you are confident of your strategy after months of research and testing. Next comes the execution of the trades.
You might have already experienced the problem of slippage when you receive a stock order that was less favourable than what you had expected.For instance, you were hoping to sell your currently-held 10 lots of Stock A at $2.00. Due to the large order, your order only had a partial fill with 5 lots done at $2, and perhaps 3 lots at $1.90 and 2 lots at $1.85.
Since pair-trading often involves taking advantage of small movements in prices, such execution problems may impact your profits.
Having said that, there are still significant advantages to consider for Pair-trading compared to the simple “buy low, sell high” strategy.
Advantages Of Pair-Trading
Limited risk – as pair-trading requires you to take an opposite position in 2 correlated stocks, it effectively works quite similarly to the idea of hedging. In this way, the risk you face is limited and somewhat controlled.
Compare this to taking a long position on 2 correlated stocks, a fall in one is likely to also see a decline in the other. In using pair-trading, such risks are reduced.
No Need for Market-Timing – for most investors using the buy low, sell high strategy, market timing is superbly important. Yet, there isn’t really anything scientific about timing the market.
The great thing about pair-trading is that it can be executed regardless of a bull or bear market, presenting more profit opportunity for an investor.In conclusion, pair trading can be a great trading idea to explore if you aren’t having much luck with market trending strategies.
However, prepare to spend some time researching on the pairs you are interested in with accurate historical modelling to ensure that you identify truly correlated investment instruments and locate high-probability pair-trading setups to help you win at this strategy.