How Pair Trading WorksMay 31, 2020
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 on this subject at another time
To profit from a pair relationship, the long would need to outperform the short on a relative basis. Both stocks could go up, both could go down, or they could diverge in your favor. Most often they are going in the same direction as they are related to each other. Again, whichever stock you are long needs to slightly outperform the short, with taking your position sizing into account also.
Finding the right pair
Pair Trading can be utilized for swing trades which allows the trader to be more “insulated” from market moves than if you held a single stock that was correlated to the market for the respective period of time.
This insulation or protection comes from choosing combinations of stocks that have a fundamental reason to be put together, not just a statistical or technical one.
Some points are listed below to assist the trader in identifying a good pair of stocks to trade:
- If we narrow our USA universe to just the SP500 stocks, it is divided into Sectors, Industries
and Segments within Industries. At the time of this post, there are 11 Sectors.
Here is the breakdown:
- Communication Services
- Consumer Discretionary
- Consumer Staples
- Information Technology
- Basic Materials
- Real Estate
- There are many Industries within the above Sectors. Stocks within industries are called peers. Even though they are peer stocks, they may operate in different Segments. Here is the comparison of the Segments of two stocks in the Basic Materials Sector and within the Chemicals Industry:
- Dupont (DD)
- Electronics & Imaging
- Transportation & Advanced Polymers
- Safety & Construction
- Dow Inc. (DOW)
- Packaging & Specialty Plastics
- Industrial Intermediates & Infrastructure
- Performance Materials & Coatings
- Property, Casualty & Reinsurance
- Dupont (DD)
From this quick comparison you can see that the rise in fall of demand, sentiment, and market dynamics on the Segments could affect the performance of the two stocks. This push or pull could make for great trading or could cause issues when the stocks going against you unexpectedly. Even if there is some business overlap, we always need to consider the areas of uncorrelated risk between two companies.
- In order to be more market neutral, form pairs from peer stocks that have greater overlap in the Segments area. This overlap and correlated risks insulate the trader from market moves.
- Companies that offer different classes of shares. Many larger organizations offer different types of share classes (think along the lines of common stocks and preferred stocks). These classes of stocks in the same company have very high correlations and can offer a good place to start for the trader new to pair trading. We went over a great example of how this can present a trading opportunity in a recent episode of the StockOdds Interviews with Successful Traders Podcast with Dennis Dick (covered at 17:52 mark).
- Good pairs are about the quality of your long stock versus a suitable hedge. You might find a catalyst for your long stock to outperform your short stock. The trader chooses the element of risk. Share classes (contractual pairs) have lower risk, but move less, whereas a pair like KO vs PEP can move around more due to competitive, fundamental, sentiment and corporate events reasons.
As it is a lot of work to create a robust database of pairs and maintain it each day, utilize StockOdds to get you started on Sector Pairs, and Stocks versus the SPY. This will save you time and offer you a probability basis for each long and short idea.
Limitations of pair trading
There are several limitations of pair trading:
- Statistics are not guaranteed. Historical relationships, correlations and cointegrations can break down. The past may not repeat. Mean reversion is not guaranteed.
- Timing is tough. You may often be early in taking an opportunity so do not all the capital you have allocated on a single bet.
- Too much size. When traders have an opinion, they often think it will work out without considering the potential losses. Always think risk first! How much are you prepared to lose on any trade? Beyond that, what are the surprises and rare events that could occur?
Diving into an Actual Pair Example
Let’s take a look at a XOM/XLE daily chart since 2011. We call this a plot of the spread price.
This is a ratio chart (blue line) of XOM’s daily closing price divided by XLE’s daily closing price over this period. Also plotted (purple line) is the 200 Day EMA (exponential moving average) to provide us with a sample rate perspective. We can observe how often it crosses that EMA, how long it persists away from it, and by how much. We can also observe the swing cycle lengths (as in how long on average before it swings back to the EMA). The EMA can be used as the “mean” but we can also observe what ratio is the midpoint over the various samples of time. We would observe that as 1.20 meaning XOM’s relationship to XLE maintains, a mean reverting balance of about 20% premium to XLE.
We can see during the current Pandemic and Oil price shocks, that the spread moved away from the EMA, but it also snapped back fairly quickly. The spread was at a premium to its central point of tendency and shorting the spread would have resulted in a profit as the spread came back to the EMA.
It should be noted in this relationship that there is an argument for this pair to be “elastic” and “contained” in range over time and maintain that price rebalancing.
XOM is a component of XLE and is 21.57% of XLE’s assets at the time of this post.
An ETF (exchange traded fund) is diversified in the sense that many stocks with different characteristics make up its assets base. XOM also has some industry and segment diversification going which contributes to smoothing its performance versus what a pure play oil stock would do.
To us at StockOdds, this is a tradeable relationship and we recommend doing your homework on it before trading. Within our Database, we have odds on the performance of this pair, odds on the stocks against the SPY ETF, and odds on the stocks individually, all for a variety of strategies, indicators and timeframes.
Pairs trading requires you to find two stocks that have a sound relationship, a reason for assembling them together, a catalyst that would have your biases work. Correlation, Cointegration and other factors may be helpful, but those statistics don’t always mean you have an edge in trading the pair.
You are looking for indications that the relationship will expand, converge, trend, or gap. You want to classify whether the pairs tendency will be mean reverting or trending. Your trading mindset, plan of action, holding times, capital restraints and whether you are trading a single pair, or a portfolio of pairs will all determine which characteristics and tendencies you are looking for.
You could be a noise trader looking for deviation from a central point of tendency of the pair to go long or short the pair or you could be looking for signals from events or catalysts. It is your choice, and there is not a “perfect” methodology. The world of Pairs is only limited to your imagination!
Find out more
At StockOdds, we have multiple courses and resources for you to learn more about pairs, or relationship based, trading, and our massive analytics database will dramatically increase your odds in becoming successful in single stock trading as well as efforts to Pair Trade.