How to Successfully Pair Trade

How to Successfully Pair Trade

Dollar Neutral Pair Trading

Pair Trading can be constructed in a dollar neutral manner, which requires employing the same amount of capital on the long and short side. This means that the purchase the long shares will be paid for with the proceeds of the shares sold short.  In a dollar neutral trade the amount of capital employed will be equal but the shares bought and sold short will not be equal.

Popular Pair Trades

A question most asked is what stocks are most suitable for pairs trading. Part of the beauty with pair trading is that there are infinite combinations of pair ideas as any two stocks can be used long or short in a pair trade.

Some popular pair trades are two similar companies in the same sector such as

  • Coca-Cola (KO) vs Pepsi (PEP)
  • Home Depot  (HD) vs Lowe’s (LOW)
  • Goldman Sachs (GS) vs JPMorgan (JPM)

A graphical representation of a dollar neutral pair trade: Long KO and Short PEP. In this example an investor who creates a dollar neutral pair by shorting .51 shares of PEP for every 1 share of KO bought. An investor would look to profit $1.03 if the pair reverted to its historical mean.

Pair Graph 1

Companies that have multiple share classes also work good mean reversion trades. As the underlying asset is the same but the valuation is different due to voting rights or country of domicile.

Some examples are

  • BHP Bilition:  BHP vs BBL
  • Comcast:  CMCSK vs CMCSA
  • Unilever: UN vs UL

A graphical representation of a dollar neutral share class pair trade: For every one share long Comcast Class A an investor would short 1.04 shares of Comcast Class K. These two stocks are 99% correlated since both are different share classes of the same company.

Pair Graph 2