Introduction to Pairs Trading

Pairs trading, also known as statistical arbitrage is used as a trading strategy to profit from
diverging prices between 2 asset classes, which has similar price movements. When the
price movements of 2 asset classes are almost identical, we classify them to be highly
correlated. When prices diverge in the short run, prices are highly likely to return to
normality to follow the same pattern in the future. This creates trading opportunities for
traders to capture with the assumption that the asset classes will revert to a pattern. Such
phenomenon is known as “mean reversion”, which I will further explain later. Traders use
pairs trading strategies because the idea is simple and the traits to look for are minimal. It
may sound fool proof to you but it is crucial to highlight that deviations may be caused by
macroeconomic factors, which generally distorts chart patterns and renders the trading
strategy invalid.

Pairs trading was developed by a quantitative group at Morgan Stanley during the 1980s,
who reportedly made over US$50 million for the firm in 1987.

In statistics, pairs trading uses the concept of stationarity. When a price movement is
stationary, the mean and variance are constant. Therefore, if there are deviations away
from the mean, reversion of prices will occur towards the mean.

Steps to conduct a pairs trade

Choose a pair to trade on

Choosing a pair to trade on is, by no means, coincidental as mentioned in the name of this
trading strategy. There are various questions you may ask yourself: “Do they need to be in
the same industry?” “Should they be only liquid stocks?”. In pairs trading, there is no hard
and fuss rule as to how you choose your pairs. Most importantly, traders look for asset
classes whose price movements are similar i.e they move together. In addition, traders may
want to restrict their pairs to be under the same broad industry categories to minimize risk
from macroeconomic influences. Broad industry categories include Utilities, Transportation,
Financial and Industrials. In fact, it is often much easier to find pairs within the same
industry. These are the common pairs that potentially correlated: Coca Cola & Pepsi,
Walmart & Target Corporation and Exxon Mobil & Chevron Corporation.

For example, I have identified the following asset class pair, which has similar price
movements. This is Coca-Cola (NYSE: KO) and Pepsi (NYSE: PEP) in a 1 year chart. In this
case, I took the price of Pepsi and divide it by a factor of 1.5 for better comparison.
Sometimes, you do get 2 asset classes which are extremely far in magnitude, i.e $0.01 and
$100, therefore, for better comparison of charts, we shift both charts closer to one another
for analysis.
 55

50

45

40
KO
35
PEP
30

25

The important point here is that the absolute prices do not matter. Here, we are trying to
analyse the similarities of price movements.

By looking at similar price movements, we are analysing the correlation graphically. To

further check if the pair are fit for pairs trading, we have to test statistically if the two asset
classes are co-integrated. There are plenty of ways to do this: informal methods (residual
analysis) or formal methods (Cointegrating Regression Durbin Watson Test or Cointegrating
Regression Dickey Fuller Test). Formal methods require additional add-ons in Excel which
may not be feasible for individuals. As a result, residual analysis will suffice if you are
interested in exploring this method.

With the historical prices of the two asset classes, run a regression between both data. For
instance, use KO as a y-variable and PEP as a x-variable in your regression analysis. There is
no fixed rule as to which asset class should be used for the x or y variable. More
importantly, we want to focus on the residuals. After running the regression, plot the
residuals over time and determine if there is a relatively constant mean and constant
variance. Ask for yourself the following: “Are the residuals fluctuating around some constant
number?” “Are the fluctuations relatively constant?” If the answer to the latter is yes, then
the pair is cointegrated and can be used for pairs trading.

Pairs Trading with Charts

Now that we have established a pair, which has similar price movements, the trading
principle is simple – trade against the current trend if both asset classes diverge from each
other. The following example is used an illustration for the trading strategy above.
Here, we have asset blue and red, which are assumed to be co-integrated. In general, we
can see that the blue asset follows closely to the red asset in terms of price movements.

Traders have to be alert and not overlook trading opportunities. We see the blue asset
converging too much into the red asset and based on mean reversion theory, we predict
that either the blue will increase and/or the red will decrease. This leads us to the following
2 trades: Long blue & Short red, in expecting the gap between to open up. As the future
prices unfold, we see that we made a profit off the blue and loss on the red. Close the
position once market neutral is established i.e similar price movements return to normal.
Technically, if you decide to hold your positions after market neutral is established, you will
still be at a profit because you have positions for both sides of the price movements.

Pairs Trading with Regression Analysis

Many will question on the amount of each asset classes to purchase and seek for the
presence of a signal, which can substantiate their trading action. After all, humans are
rational and act only if there are grounds to do so. Before you start on regression, you will
need the following: 1) historical prices of each asset class 2) excel or similar programs that
can run regression. Historical prices are easily found in Google Finance or Yahoo Finance
sites. I will illustrate the following example using Stock Y and Stock X.

The first step, as mentioned before, is to run a regression between Stock Y and X. You can
run Y with X to get an equation Y  b  b X  e
or X with T to get X  b  b Y  e
.
For my explanation, I am using Y with X as an example.

The second step is to take the actual Y data minus off b ∗ actual X to get what I call a
shifted error term. We are essentially tweaking the regression on top to becomeY  b X 
shifted e
. The b is insignificant in our analysis as it is a constant number that will only shift
the errors up or down. The crucial factor here is that the error must have a constant mean
and variance, which was mentioned in part (a) that the condition has to be fulfilling in
choosing a pair. The shifted error can be imagined

The third step is to determine the mean and standard deviation of the errors. In excel, the
functions are =mean and =stdev. Standard deviation measures the variability of the error
term. Based on your risk adversity, you can set then number of standard deviations for the
error to reach before taking a trading action. The following example will better illustrate
what I have explained previously.

Pairs Trading Example: Y and X

200.00
100.00
0.00
-100.00
-200.00
-300.00
-400.00

Remember, the equation here is Y  b X  shifted e

. Here, the pink solid line is the mean
and the 2 dotted lines are ±2 standard deviations. Therefore, when shifted e
is moving
towards +2 standard deviation, the 2 price curves are diverging (moving away from each
other). This causes the gap between to widen therefore, a pairs trader will want to take a
Short Y and Long X position. To be more specific, we short 1 unit of Y and b units of X. We
do this because using the coefficients from the regression equation allows us to profit
statistically from shifted e
. It is important to note that deciding on your own number of
units may result in a loss even though the prices did return to normality.

When the shifted e

is moving towards the -2 standard deviation region, prices are
converging (moving towards each other). This causes the gap to narrow and the appropriate
trading strategy is to long 1 unit of Y and short b units of X.

Disadvantages of Pairs Trading

The first step in picking a pair is often the hardest because there are too many asset classes
to look at. The chance of finding a pair alone is often derived by luck.

Pairs trading may not work out as price changes can arise from fundamental changes in the
macro economy or the industry. A general rule of thumb is to avoid holding positions for
excessive periods of time. What constitutes excess time is dependent on how much you are
willing to risk. If the two curves are truly cointegrated, prices will eventually return to
normality. However, traders may not have enough funds to sustain the fluctuations prior to
making a profit.

Individuals are slightly disadvantaged in pairs trading, as they often do not possess the
required technology to gain an edge in the market. Pairs trading require the constant
updating of latest closing prices. After which, the statistics have to be recalculated again to
manage positions in the market. Also, deviations from normality may occur during the day
and the presence of computer macros can relieve the need for constant monitoring of the
markets.

Conclusion

This is basically how pairs trading work. There are many variations of pairs trading out there,
some work based on price ratios eg. Price of Y / Price of X and some of them use
mathematical derivatives that you may not have seen in your life. The above-mentioned
way provides you with a good overview of how pairs trading work and perhaps, this can be a
stepping stone to understand other pairs trading variations out there.

Since historical prices are widely available online, traders have made use of computer tools
to quantify the similarity between two price curves. If you are interested in this, you can
read on Spearman’s rank-order correlation and how it is used in pairs trading.

Zhang Zhihua

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