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PAIR
TRADING INTRODUCTION
- by Darren Clifford
Pair
trading is going long one stock and
short a different stock to hedge your
risk.
It
is a tool used to create more
predictability in your trades and
profitability in all markets.
Pair
trading can be used in conjunction
with many other trading strategies, as
fundamental and technical analysis can
still be used.
Naming
A Spread
A
pair is made of a lead stock and a
secondary stock.
If
you look at the pair Aa (Alcoa) and Al
(Alcan), and you refer to it as AaAl,
then Aa is the lead stock and Al the
secondary.
If you called the pair AlAa
then Al would be the lead stock and Aa
the secondary stock.
In
this case the lead stock simply means
the first stock in the name of the
pair, it has nothing to do with market
leadership or the size of the
companies.
To standardize spread names
most are named alphabetically.
Some
pairs are traded with a ratio applied
to the lead stock.
If you trade two shares of Aa
for every one share of Al then the
ratio would be 2 to 1.
To
add this ratio to the spread name the
ratio is expressed as a percentage and
added to the end of the spread.
AaAl,
with a ratio of 2 to 1, would be named
AaAl200.
AaAl, with a ratio of 1 to 2,
would be named AaAl50.
The 50 is derived from dividing
1 by 2 and then expressing it as a
percentage.
Even
if a spread is traded 1 to 1 it still
will have the ratio in its name, like
AaAl100.
An
Example
The
chart below shows the spread AaAl100,
or 100% of the last price of Aa minus
the last price of Al, from www.pairtrader.com.
You
can see that the spread has a low of
around –$6.50 and a high of around
– $2.50, for a range of $4 during
the last three months or 65 trading
days.
During
the time period of this chart Al has
always been priced higher then Aa, but
the price difference has been
decreasing.
You
can see on the below individual stock
chart of Aa over the same time period
that the stock’s high was just over
$31 and the low was $26 for a range of
$5.
During
the last three months the stock has
been on a downward trend and finished
around $4 off its initial price.
Al,
over the previous three months has had
a high of around $38 and a low of
around $29.50 for a range of $8.50.
Trading
the spread smoothed the trading range
to $4 from $5 for Aa and $8.50 for Al.
This is a great example of how
a spread decreases the risk you face.
During
the three month time period you can
see that both stocks decrease, but Al
decreases by a greater amount then Aa.
This causes the spread to
increase as the price differential
decreases.
Notice
how the spread price behaves in a
direct relationship with the lead
stock (as the lead stock goes up, the
spread price increases), and in an
indirect relationship with the
secondary stock (as the secondary
stock goes up, the spread price
decreases).
Establishing
A Position
When
you take a position in a pair you can
go either long or short the pair.
Going
long a pair means that you go long the
lead stock and short the secondary
stock, going short the pair means that
you go short the lead stock and long
the secondary stock.
The
direction you trade the lead stock
tells you the direction you trade the
pair.
Traders
need to be comfortable going both long
and short pairs.
Pairs
differ from stocks in that there is no
minimum price; negative spread prices
are common. |
