We recommend reading What is Pair Trading before the rest of this article.
We think of the combined stocks as a “unit”. We can either be Long or Short the unit or the pair.
If the pair we chose was XOM vs XLE and we always kept XOM as the first symbol and XLE as the second symbol, then we could combine them as XOM/XLE (ratio) or XOM-XLE (differential). We would say we are “Long the Pair” if we were long XOM and short XLE. Conversely, we would be “Short the Pair” if we were short the first symbol (XOM) and long the second symbol (XLE).
There is no correct way on how to structure the pair, but rather it is trader preference. The key is to choose what works for your trading and data platforms, as well as the time frames you are trading in.
For someone who wants to hold overnight, it could look different than for the day trader.
That being said, we have our preferred method and style of setting up and naming a pair. More...
The concept of pairs trading, or relationship-based trading, comes from Morgan Stanley, where a group of researchers first developed the strategy in the 1980s. Simply put, pairs trading requires you to match a long position against a short position on a pair of stocks that are highly cointegrated. There may also be high correlation as they track together through market fluctuations. Once you find the some great pairs to trade, it can be a very effective trading strategy, insulating you from the market gaps, reversals and overall volatility, but tracking, executing and managing the combinations takes knowledge, time, skill, historical and current data.
Relationship-based trading helps to identify probability and predictability. Volatility increases your chances to take trades over and over again increasing production on a pair or portfolio of pairs. You may be able to identify the leading stock and the stock that lags. This will assist...
Jesse Livermore was born on July 26, 1877 in Shrewsbury, Massachusetts. When Jesse was 14 years old, he ran away from his father’s farm and started working at a brokerage posting stock quotes. Excelling in mathematics, he quickly gained a feel for the markets.
A year later, at the age of 15, he started putting his theories to the test. With very little capital to use at his young age he started placing wagers at his local bucket shop. A bucket shop was a gambling house for stocks where participants could bet on the direction of any stock. Jesse quickly made his first $1000 (the equivalent of $27,000 today) and quit his day job at the brokerage. He made so much, however, that the bucket shop owners grew tired of handing over their money to Livermore and permanently banned him from their establishments.
By then Livermore had made more than enough to try his hand in the actual stock market.
He found his bucket shop strategies ineffective in the new environment and went to work...