@ethan hunt, Apologies for the late revert.
1156 hits so far on this Thread.....wow. Didn't know that a lot of guys are interested in Pairs Trading. If thats true, apologies to all.
Pls find below some more information on Pairs Trading :
•
Pairs Trading is a process of buying the cheaper stock and selling the costly stock simultaneously in the Futures segment to benefit from all kinds of market condition.
• When two correlated stocks are chosen for the trade with market neutral approach then the trading method is known as Pairs Trading. Example: HDFC Bank and Axis Bank both in the private banking sector and have close similarity in the business model.
• How to choose pair of stocks for trading?
o Both the stocks must be from the same industry.
o Stocks must be a component of a sectorial index.
o Stocks must have a close correlation in business model and business structure.
o Technical Parameters :
The volatility in annual terms for the pair must not defer by 50%, i.e., if the annual volatility of one stock is 50%, then the other stock should have an annual volatility of more than 25% & less than 75%. A plus / minus 4-5% in the annual volatility of other stock is considered ok.
The Annual Volatility of both the scrips should be more than 20%.
The high volatile stock (as per the % Annual Volatility) will be the dominating partner in the pair, i.e., it becomes the Independent Stock (X), while the other becomes the Dependent Stock (Y). But if the pair has one Index and one Stock, then the Index becomes Independent, while the Stock becomes Dependent.
The correlation coefficient of the pair must exist either in the +ve or –ve zone
The spread difference between the stock must show some correction
• Important Statistical parameters for pairs trade :
o
Correlation Coefficient :
This statistical parameter gives a value between -1 to +1.
A Positive correlation means both the stocks in the pair will move in the same direction, while a Negative correlation means both the stocks will move in the opposite direction.
If the correlation is '0' means both are moving randomly.
An ideal correlation is +/- 0.6018.
For Positive Correlation, the recommendation to buy & sell should be followed as is. But in case of Negative Correlation, the recommendation received should be reversed and then traded. This means that if the recommendation received is to [Buy Stock 'A' and Sell Stock 'B'] and in case of Pairs with Negative Correlation, one should do the opposite, i.e, [Buy Stock 'B' and Sell Stock 'A'].
o
Hedging Using Options : It is always a good practice to hedge the pairs using Options as Pairs can sometimes lead to huge losses if not managed properly. Though this will reduce the profits, but it will also ensure that the losses are minimised.
o
Ratios : One can use Jensen's Alpha Ratio, Sharpe Ratio & Treynor Ratio to identify the expensive and cheaper stock. The stock with higher Jensen Alpha Ratio, higher Sharpe Ratio and higher Treynor Ratio is expensive and hence needs to be sold, while the cheaper stock needs to be bought.
Jensens Alpha Ratio = Return on the stock 1 - (Interest Rate + Stock Beta * (Return on Stock 2 - Interest Rate))
Sharpe Ratio = (Return given by the stock – Risk free Interest rate) / Annual Volatility
Treynor Ratio (Reward to Volatility) = (Return on stock – Risk free Interest) / Beta of the stock.
* I use the Risk Free Interest Rate of 3.50%
•
Trade Initiation Process : A trade will be initiated if one of the following criteria is met,
o If the
Current Spread is above or below 2% of the Mean Spread. (The Current Spread is the price difference between the two stocks.)
o If the correlation changes from + ve to – ve or vice versa.
o If the correlation increases or decreases by 50% from its previous recorded data.
These are the basics of Pairs Trading. Those who are really interested will need to do a lot of research on it and experiment with Paper Trading before actually going ahead with real trades.
Apart from checking the links provided above (Post # 29), I would recommend those interested in Pairs Trading to also visit "http://www.smartfinancein.com/" and register for the free webinars on this topic. They have uploaded on their site some e-books and videos on various strategies including Pairs Trading. (Kindly note that I do not have any commercial interest in recommending Smart Finance. One of my friends recommended me this website and it has immensely helped me.) Further, I would also like to inform that I have read mixed reviews about them and there are a quite a few people who do not find their strategies profitable but it is up to us as to how we can benefit from them. Also, I would like to update that the above mentioned details on Pairs Trading have been taken from a free webinar given by Mr. Soumya Ranjan Panda, the Proprietor of Smart Finance.
One should also visit the following sites for more information on Pairs Trading :
http://www.yats.com/doc/cointegration-en.html
http://blog.echen.me/2011/04/16/what-is-cointegration-2/
https://www.tradestation.com/en/education/labs/analysis-concepts/market-neutral-pairs-trading
http://www.investopedia.com/articles/trading/04/090804.asp#axzz1pa3ppYGV
http://www.tradingmarkets.com/.site/stocks/how_to/articles/-76543.cfm
http://yeforex.blogspot.in/2010/02/pairs-trading.html
Do revert in case of any further clarifications. Shall try my level best to answer the same to the best of my abilities. [I would like to inform that I am no expert on this topic (so far). But the research is on and I am confident that some day (sooner than later), I will be one.]
Hence, would urge the seniors & experts on this topic to kindly share their findings & observations so that every one can benefit from it.
