What is Pair Trading?

[Mahender]

The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy. The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s.

The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens, i.e. one stock moves up while the other moves down, the pairs trade would be to short the outperforming stock and to long the under performing one, betting that the "spread" between the two would eventually converge. The divergence within a pair can be caused by temporary supply/demand changes, large buy/sell orders for one security, reaction for important news about one of the companies, and so on.

Pairs trading strategy demands good position sizing, market timing, and decision making skill. Although the strategy does not have much downside risk, there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity.

Extracted from Wiki.  Click here for full article

Further Reading

Pairs Trading by Thomas Preston

 

Pairs Trading, Convergence Trading, Cointegration by Daniel Herlemont

The Secret To Finding Profit In Pairs Trading by Chris Stone

A Basic Introduction to Pairs Trading by Dave Goodboy

Statistical arbitrage and pairs trading by Nikos S Thomaidis

Pairs Trading:Quantitative Methods and Analysis by Ganapathy Vidyamurthy

[Mahender PTG]

There are generally two types of pairs trading: statistical arbitrage convergence/divergence trades, and fundamentally-driven valuation trades. In the former, the driving force for the trade is a aberration in the long-term spread between the two securities, and to realize the mean-reversion back to the norm, you short one and go long the other. The trick is creating a program to find the pairs, and for the relationship to hold.

The other form of pairs trading would be more fundamentally-driven variation, which is the purvey of most market-neutral hedge funds: in essence they short the most overvalued stock(s) and go long the undervalued stock(s). It's normal to "pair" up stocks by having the same number per sector on the long and short side.

 

Extracted from Pairs Trading, Convergence Trading, Cointegration by Daniel Herlemont

 

Sheet 1: Ratio Analysis contains pairs with fundamentally-driven valuation trades (Calculations are based on Ranjan Sir's Ratio Analysis method) Pls follow this video link for this stratergy.

Sheet 2: Price Ratio & Spread Analysis contains statistical arbitrage convergence/divergence trades

As for as the Amount required for initiating a pair trade depends on type of instruments you are using.

1. Plain Futures

Buy 1 lot SBIN

Sell 1 lot ICICIBANK

2. Futures with options protection

Buy 1 lot SBIN and buy 1 lot SBIN put

Sell 1 lot ICICIBANK and buy 1 lot ICICIBANK call

3. Futures with protecting 1 symbol with option

Buy 1 lot SBIN

Sell 1 lot ICICIBANK and buy 1 lot ICICIBANK call

4. Only Options

Buy n lot(s) SBIN call

Buy n lot(s) ICICIBANK put

5. Cash Neutral Method - In this method you match the cash for sell and buy

Ex: if we want to initiate BANKBARODA and AXISBANK pair

BANKBARODA 250 x 663  = 165750

AXISBANK        250 x 1063 = 265750

There is 1 lakh cash difference between this pair

 

a) If you are going long BANKBARODA and short AXISBANK then

Buy 1 lot BANKBARODA

Sell 1 lot AXISBANK

Buy 150 shares of BANKBARODA in the cash market to compensate the cash difference of Rs.1,00,000

a) If you are going long AXISBANK and short BANKBARODA then

Buy 1 lot AXISBANK

Sell 2 lot BANKBARODA

Buy 62 shares of AXISBANK in the cash market to compensate the cash difference of Rs.65,750

 

Considering the market setup, holding period and available funds, we have to select instruments.

 

For margin required for holding futures, check your broker, as each symbol requires different margin amount.

 

You will require approximately Rs. 70,000 to 1,00,000 for a single naked pair using futures.

 

Options require full amount, same with cash market.

Always have minimum 20% buffer balance for each pair.