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Pairs Trading with Little Volatility |
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Thursday, 06 December 2007 |
Pairs trading was always a secret until the internet was developed. Pairs trading is a quantitative analysis strategy that was developed by some quants at Morgan Stanley back in the 80's.
Correlation and Volatility
The key to a successful Pairs trade is to find two highly correlated securities that have little volatility. The ADX indicator can be used to determine a trend direction and measure the volatility. Correlated investments are usually two stocks in the same sector, two specific interest rates, two specific commodities, etc.
How to Pairs Trade
Pairs Trading is a low-risk strategy that is market neutral. Market direction does not matter because we are looking for low volatility when we screen for a pair. We also want to know the mean trend of our securities by looking at support and resistance lines, or an EMA. This correlation between the two securities (Ex: Ford and GM) is also known as the "relative performance".
The trick is that there is always an under performer and an over performer in a pair, since no two pairs follow the same exact price movements daily. A true quant with proper trading systems will create a price ration between the two picks you choose, and then overlay that chart with standard deviations from the mean price. Once this ration hits a certain deviation, you long the under performer and short the over performer.
Since the cost of these systems is a fetter to many traders, we can come up with another way to pairs trade: once the over performer hits a peak, short the over performer and long the under performer, since the under performer usually trails the over performer if they are correlated. The same can be true if the market is declining. Long the under performer while shorting the over performer.
The chart in the above shows an example of two correlated trends with a trailer (under performer) and a leader (over performer). The revenue from the security that you long will make up for any losses in shorts (because the trends will never invert). Pairs trading is highly profitable if done correctly, but like all strategies, it should not be used alone.
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