Introduction To Pair Trading
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 above chart is 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 above individual stock chart of AA over the same time period
that the stocks 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.
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.