Pairs Trading: A Market Neutral Trading Strategy

Many a time, traders come across the term “risk-free trading”. Although in reality, it is virtually impossible to trade a purely risk-free strategy, certain strategies can definitely fit the description of having less downside risk than others. Without a doubt, Pairs Trading falls into this category.

Pairs trading involves the idea of choosing two correlated financial products (or groups of products), figuring out what their historical correlation is, and making the assumption that this correlation will hold true in the future. Essentially, a trader is betting that more likely than not, this correlation should hold true in the future. A skilled trader with proper knowledge of position sizing can effectively apply the concepts of Pairs Trading into his/her day-trading strategies.

The Benefits of Pairs Trading

Pairs Trading can be beneficial because it protects the trader from market wide sources of risk. A Pairs Trading strategy that is market neutral can protect the trader from market-wide fluctuations. For example, if two stocks are highly correlated, a trader can sell the outperforming stock and purchase the under-performing stock. If the trader holds on to the belief that their relative correlation will come back to normal, then he/she is hedged against market-wide movements; eventually, when the stocks regain their historical proportion/correlation, the trader can square off his/her two positions and earn a profit.

Here is a basic example. Here are the daily closing prices of Reliance Industries (NSE:RELIANCE) and Essar Oil (NSE:ESSAROIL) for the past 7 trading days:

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The correlation can be calculated easily in Microsoft Excel by using the CORREL function.

Since the two products seem to be highly correlated, a trader can look make the judgment that the ratio between the two products should be between 11 and 13. Assume that the next day, the trader notices Reliance trading at 800, while EssarOil is trading at 73. The trader calculates that the ratio between the two products is less than 11 (800/73 = 10.95). Therefore, it seems that this is a good opportunity to get into a trade. In this example, the trader would sell EssarOil and buy Reliance since Reliance is relatively under-performing and EssarOil is relatively over-performing.  Since the ratio is approximately 11, the trader would sell 11 shares of EssarOil for every share of Reliance that he purchases.

At this point, the trader’s true test arises: when should he/she exit the trade? Patience can be the most difficult aspect of trading! Eventually, the trader is looking to exit the trade once the ratio stabilizes to above 11 and the trader can earn a profit. It is generally a good idea to set yourself a profit objective (and if possible, a stop loss) when entering a trade. In our example, the trader might set the profit objective to be a ratio between the two products. Since the trader felt that 13 was the relatively high ratio between the two products, he/she can set 13 as the ratio the products must hit in order for him to exit the trade.

Eventually, the trader notices Reliance is trading at 760 and EssarOil is trading at 58.45. The ratio has breached 13! The trader immediately sells Reliance and purchases EssarOil.

If he/she had executed 110 shares of EssarOil and 10 shares of Reliance, his/her net profit (before costs) would have been:

EssarOil: (73-58.45) x 110 = Rs. 1600. 50 profit

Reliance: (760-800) x 10 =  Rs. 400 loss

Net: Rs. 1200.50 profit

As you can see, although the market had dropped between his two series of transactions (both Reliance and EssarOil fell in price), the trader was able to earn a profit by hedging his trades. This is the power of Pairs Trading!

Getting Started

Pairs trading, in its simplest form, can be done by calculating the correlation between any two single financial instruments. Similar to the above example, a trader can use the same exact concept to do Pairs Trading on Cash-Futures arbitrage. This is where you would pit the near month futures product of a security against its Cash underlying.

There are a few important concepts to remember if you want to implement a Pairs Trading strategy.

1. Ensure that it makes intuitive sense for the two products to be correlated! For example, a trader might notice that a Nifty Call Option seems to be highly correlated with USD/INR January Futures by plugging in the data and calculating the correlation. However, just because the data shows a correlation does not mean that there is a cause for the correlation! As the old adage goes, “correlation does not imply causation!”
2. Use a high sample size to calculate the correlation. In the earlier example, we used only 7 days worth of data for calculating the correlation between Reliance Cash and EssarOil Cash; a knowledgeable trader should look to ensure that the stocks have had a steady, consistent correlation for many months before making his/her trading decisions.
3. Use proper position sizing! In our previous example, we executed 11 shares of EssarOil for every share of Reliance. In general, it is wise to ensure that the market value of the two transactions is as close as possible.
4. Use profit objectives and stop losses. After entering a trade, implement a mental stop loss and profit objective; this keeps the guesswork out of the game and allows you to trade emotion-free. The profit objective and/or stop loss can be hard prices or based on ratios.

Conclusion

In conclusion, Pairs Trading can be a highly effective way for you to hedge your risks while trading. It does a good job at eliminating the market-wide risk that allows you to remain market neutral. While you probably will not earn a large amount on any one trade, your downside risk is also minimized which gives you peace of mind. If you are willing to do some homework, implement proper position sizing, and are able to remain patient, Pairs Trading can be an effective way for you to hedge your risks in all types of different market conditions.