Pairs Trading Strategy and Statistical Arbitrage
Pairs trading strategy is a market neutral strategy which enables traders to profit from virtually any market condition; uptrend, downtrend or sidewise movement. Although introduced in early 1980’s the strategy became popular among retail traders only after the introduction of online trading though sophisticated trading systems. Opportunities of pairs trading usually last for only a short-period of time thus quick response to market movements is required, which can only be achieved by high degree of automation.
The first and most important step in pairs trading strategy is to find pairs. Pairs are trading instruments (stocks, options, futures, currencies, bonds, etc.) which show great correlation; that is the price of one move in same direction of the other. For stocks, pairs can be shares of two companies in same (or related) industry. For options, it can be options on highly related stocks. For futures it can be mini and full-size contract or can be futures of related (same) industries. And for forex it can be currencies of countries having good trade relations. Traders should use various fundamental and technical analysis tools to find these pairs. Once pairs are identified the strategy is simple.
Pairs traders look for divergence of correlation between shares of a pair. When a divergence is noticed, traders take opposite positions for instruments in a pair. For stocks, currencies and futures, the trader takes long position for under performing instrument and short position for over performing instrument; for options, the trader writes put option for underperforming stock and call option for outperforming stock. In most cases cost of taking one position is compensated by the revenue from the opposite position. Trader is profited when the divergence is corrected and the instruments are brought to original (near original) correlation by market forces.
Pairs trading strategy demand good position sizing, market timing and decision making skill. Although the strategy does not have not much downside risk there is a scarcity of opportunities and, for profiting, the trader must be one of the first to capitalize on the opportunity.
Statistical Arbitrate, popularly called StatArb, is the broad scale application of Pairs trading strategy. The strategy is to profit from pricing inefficiencies in the market and to make profit by tracking divergences from correlation. But unlike pairs trading, the StatArb include downside risk.
In statistical arbitrage, traders constitute portfolios consisting of a number of different stocks, which are carefully matched for reducing market risk and stock beta. Stocks are carefully screened using fundamental and technical tools; this includes industry, beta, volume, growth, value and performance history. Usually the stocks in the portfolio are scored using mean-diversion principle and other mathematical models. Usually the stocks which are underperforming receive high scores; and outperforming stocks receive low scores. The strategy is to take long position on high score stocks and take short positions on low score stocks.
With both pairs trading and statistical arbitrage continuous data mining, market and price analysis and price matching are important. High position sizing, low trading costs and better trading platforms can offer better profits.
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