How To Approach Pair Trading
Editor’s note: In this article, Darren
Clifford begins to explain the basics of Pairs Trading. In several follow-up
articles, Darren will teach you the advantages of this style of trading. And in
the future, he will provide you with actual setups that are occurring the
current markets.
If you are unfamiliar with what Pairs Trading
is, here is how Darren explains in a recent interview:
Pair Trading is when you are trading from a
hedged position. I would be looking at two correlated stocks like Coke and
Pepsi. I may buy one, and short the other to play the price differential between
the two. This allows the trade to be a lot more stable and a lot more
predictable. There are a lot of old school traders who crave and love volatility
and they just wish the markets would move again. As a professional trader, I
don’t care a bit about volatility, I care about predictability. Even if
something is highly predictable in small patterns, I can trade it in a lot
bigger size to make my money out of it. If something is moving all over the
place, yet I can’t predict where it is moving, it is going to be trouble and I
can be losing a lot of money.
And now, here is Darren’s first article for
TradingMarkets.
When you approach pair
trading don’t throw away your prior experiences, it is good to start
with a sector that you are familiar with. This way you have a head start on how
things work in that sector.
When approaching a new sector it is helpful to find enough companies in the
sector that are actually tradable. Ideally you will find at least 4 stocks
in a sector that have a significant enough trading volume and market
capitalization to trade. When you have too few stocks that make up a sector you
can get anti-correlated pairs as money is moved out of one side of your pair
into the other.
When reviewing a sector you should look for any indexes corresponding
specifically to the sector are present, as well as whom the market leader is in
that sector. Some sectors have regular news events that happen weekly or
monthly. As well you should check to see if there are any legal events or merger
tendencies that affect your stock.
Take a look at the following list of oil companie
| Company | Symbol | Market Cap | Average Volume |
| Exxon Mobil Corp | ( XOM | Quote | Chart | News | PowerRating) |
370B | 17.2M/day |
| British Petroleum | ( BP | Quote | Chart | News | PowerRating) |
240B | 3M/day |
| Royal Dutch | ( RD | Quote | Chart | News | PowerRating) |
122B 2 | .1M/day |
| Chevron | ( CVX | Quote | Chart | News | PowerRating) |
122B 7 | .7M/day |
| Conoco Phillips | ( COP | Quote | Chart | News | PowerRating) |
87B | 6.3M/day |
Each of these companies trade a significant amount of volume and have a large
enough market cap so that other traders and funds can’t manipulate the price of
the stocks.
You can also use the OIX as an index for the sector to help with determining the
direction and movement of the oil industry.
Get ready to put all of these new skills into practice as we transition into
specific trade ideas.
Darren Clifford
Darren Clifford is a professional equities
trader with Bright Trading. Mr. Clifford has recently been ranked one of the top
30 traders under 30 by Trader Monthly magazine.
Mr. Clifford holds a masters degree in Economics from Simon Fraser University
specializing in Financial Mathematical Modeling. He is also the president of
www.pairtrader.com, company dedicated to providing the tools and data necessary
for hedged equity trading.