Pair trading is a strategy that entails holding both long and short positions in equities with a high correlation. Pair trading can be analogous to an interstate highway and a service road.
The main highway is often a lengthy, concrete road, whereas the service road runs parallel to both sides. The service road gives access to businesses, residences, farms, and commercial and industrial zones along the highway. On either side, both highways run parallel. If the highway is angled in one direction, the service road is angled in the opposite direction. The path is comparable except for minor barriers on the service road, which could be a tree or a pole.
Pair trading logic is similar in that the stocks you acquire are in the same industry but are owned by different firms or brands.
Numerous characteristics of pair trading
When compared to the preceding scenario, the following characteristics of pair trading apply:
The highway and service road are investment vehicles. Consider Stocks A and B.
The relationship between the highway and service road represents the relationship between Stock A and B. Stock A’s market impact will be similar to Stock B’s, and both stocks behave similarly.
As with an obstacle on a service road, certain circumstances may result in a breakdown of the correlation between the stocks.
The effect of a deviation:
Correlation deviations are often transient, with equities quickly reestablishing their link.
Consider two companies – Hero MotoCorp and Bajaj Auto – both private automotive manufacturers in India.
Both companies offer comparable products, target markets, and clients.
Both companies have a substantial presence in India.
Both are confronted with similar obstacles, regulations, and constraints.
Both are closely related. As a result, a change in market conditions will have a comparable effect on both businesses. For instance, an increase in fuel price will have a detrimental effect on both the industry and the businesses. Taking everything else into account, if the stock price of Hero MotoCorp goes in a particular direction, the stock price of Bajaj Auto will almost certainly follow suit.
On the other hand, the stock prices of the two firms do not move in lockstep, and this is a perfect trading opportunity. This is the essence of pair trading. As a result, pair trading is typically centred on the following strategies:
Determining the stock-to-stock relationship
Numerous investors will hunt for assets within the same industry or area, and correlations between organisations in distinct sectors are typically weaker. For instance, a shift in the raw materials used to manufacture autos will affect Hero Moto but not HDFC bank.
Conducting a correlation analysis between the stocks
Correlations of 0.85 are deemed satisfactory for pair trading. Over the previous year, Hero Moto and Bajaj Finance have correlated with 0.87.
Continually monitoring the correlation
Correlation is the term that refers to the degree to which two variables are reliant on one another or move in lockstep. Correlation coefficients range between -1 and 1. A correlation of -1 indicates that the securities are perfectly inversely related, meaning that if one climbs by 50%, the other decreases by 50%. A correlation coefficient of zero shows that there is no association, whereas a correlation coefficient of one indicates that there is a perfect positive correlation.
Checking for correlation abnormalities
Finally, one must locate trading opportunities. Tracking the correlation’s deviation enables traders to identify trading opportunities. These could be short-term or long-term in nature.
What is stock market pair trading?
As noted previously, an anomaly in related securities creates an opportunity for trading. Anomalies in pricing could be caused by various events, including excessive speculation in trading, the announcement of quarterly earnings, or a change in top management. A pair trading technique entails spotting such anomalies and taking long positions in one and short positions in the other to profit from the momentarily weakened correlation. The objective is to capitalise on the transient variation in correlation, expecting that the gap would eventually return to its original state.
Stock pair trading entails taking a long position in the underperforming security and a short one in the outperforming security. If the securities revert to their initial correlation, the profit is realised. Thus, in pair trading, the entry and exit positions are well defined.
Consider two securities – ICICI Bank and HDFC Bank – that historically had a strong correlation of 0.95. The Reserve Bank of India issues directions to HDFC Bank about the issuance of credit cards. As a result, the price of HDFC Bank falls substantially, and the correlation between the two securities decreases to 0.50 in the short run. The trader will then take a long position in HDFC Bank and a short position in ICICI Bank. With time, HDFC Bank’s price rebounds and the correlation between the two securities reverts to 0.95. The trader profits from both the long and closed short positions.
The Benefits of Pair Trading
The primary advantage of pair trading is risk reduction. Contrasting trades are made on securities that have a high degree of correlation. Profits are realised when an underperformer regains its worth, and an outperformer deflates.
However, to maximise earnings from pair trading, the assets must be highly connected. Correlations between stocks must be at least 0.80. However, such securities are difficult to identify.
To summarise, pair trading is frequently said to be a market-neutral technique due to the simultaneous holding of long and short stock positions. This idea is faulty because the opposing positions are held on two different equities. It is critical to understand the dangers associated with pair trading, as the objective is to profit from the relative values of the two stocks. IIFL’s equity experts can assist you to comprehend the risks and rewards of stock market trading, making them the ideal consultants on your journey through the stock market.