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What Is Pairs Trading

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					What Is Pairs Trading?1

"Quants" is Wall Street's name for market researchers who use quantitative analysis to develop profitable trading strategies. In short, a quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to divine profitable trading opportunities. During the 1980s, a group of quants working for Morgan Stanley struck gold with a strategy called the 'pairs trade'. Institutional investors and proprietary trading desks at major investment banks have been using the technique ever since, and many have made a tidy profit with the strategy. It is rarely in the best interest of investment bankers and mutual fund managers to share profitable trading strategies with the public, so the pairs trade remained a secret of the pros (and a few deft individuals) until the advent of the Internet. Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn't take long for the pairs trade to attract individual investors and small-time traders looking to hedge their risk exposure to the movements of the broader market.

What Is Pairs Trading? Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss. The goal is to match two trading vehicles that are highly correlated, trading one long and the other short when the pair's price ratio diverges "x" number of standard deviations "x" is optimized using historical data. If the pair reverts to its mean trend, a profit is made on one or both of the positions. An Example Using Stocks Traders can use either fundamental or technical data to construct a pairs trading style. Our example here is technical in nature, but some traders use a P/E ratio or other fundamental factors to measure correlation and divergence. The first step in designing a pairs trade is finding two stocks that are highly correlated. Usually that means that the businesses are in the same industry or sub-sector, but not always. For instance, index tracking stocks like the QQQQ (Nasdaq 100) or the SPY (S&P 500) can offer excellent pairs trading opportunities. Two indices that generally trade together are the S&P 500 and the Dow Jones Utilities Average. This simple price plot of the two indices demonstrates their correlation:

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from www.investopedia.com/articles/trading/04/090804.asp

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For our example, we will look at two businesses that are highly correlated: GM and Ford. Since both are American auto manufacturers, their stocks tend to move together. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ from: http://www.esignalcentral.com/exchange/07_2005/third_party_spotlight.asp Market neutrality is a major feature of pairs trading. The term “market-neutral” has come to be a quite appealing label in the last several years and can refer to a wide variety of strategies. Many investors mistake the term to mean “risk free”. This misconception has been narrowly focused on in the marketing of these types of products, and, often, the label is applied to anything that could be considered, even loosely, something that reduces market exposure or systematic risk. A market-neutral strategy derives its returns from the relationship between the performance of its long positions and its short positions, regardless of whether this relationship is done on the security or portfolio level. ^^^^^^^^^^^^^^^^^^^^^^^

See next page as well ->>>>

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This section by by Pank Agrrawal Table of the basic positions in a pairs trade Type Classic Pure Stock Play Sector Play Double Alpha Sector Play Macro Market Play Crossed Assets “I want a new drug” Play Long Stock Stock Sector ETFs Sector ETFs Market 1 ETF Equity Market ETF Any ETF Short Stock Sector ETF Market Sector ETFs Market 2 ETF Bond ETF Stock Risk High Moderate Moderate Moderate+ Moderate+ High Very High

Non-convergence or error maximization are known problems with the pair trading strategy. BA and LMT have about a .56 correlation (quite high, see embedded table). See this chart below: If you shorted BA you’re now in dire straits, and this is a 4 year chart.. How much longer will/can you endure it?

Correlation Table LMT BA

SPY

DIA

RTN

F

GM

EFA

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LMT BA SPY DIA RTN F GM EFA

0.0 0.5623 0.3463 0.342 0.2323 0.1257 -0.1948 0.0236

0.5623
0.0 0.8147 0.7383 -0.3794 0.3673 0.4827 0.5575

0.3463

0.342

0.2323

0.1257 0.3673 0.2825 0.2197 -0.5537 0.0 0.5057 0.2486

-0.1948 0.4827 0.5962 0.5735 -0.8665 0.5057 0.0 0.7602

0.0236 0.5575 0.637 0.5522 -0.5496 0.2486 0.7602 0.0

0.8147 0.7383 -0.3794 0.0 0.861 -0.5405 0.861 0.0 -0.5437 -0.5405 -0.5437 0.0 0.2825 0.2197 -0.5537 0.5962 0.5735 -0.8665 0.637 0.5522 -0.5496

To see a full ETF correlation matrix to understand the cross-correlations on various markets, sectors and asset classes, you can go to: http://advancedportfoliosolutions.com/aps-research.html It is a 37x37 matrix that utilizes a two year daily return series and is thus based off 1 million plus unique data points. A new addition is the Top and Bottom 25 paired correlations. A high pairwise correlation is a high Sharpe ratio proposition [safer], while a low pairwise correlation scenario is a high Alpha potential [riskier].

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