Trading on stock exchanges around the world is one of the most profitable and “sexiest” enterprises one can come across. It does not require any employees, office, or customers. In business terms, relatively low capital is required for the start, and it can be quickly converted into real riches. Who would not want to make millions?
Trading stock pairs
Banks have looked for reliable and stable exchange trading strategies since the beginning of their existence. Dozens, or even hundreds of more or less successful methods have been devised over the years. Some strategies have only worked on a short-term basis, others made money for decades. A strategy that has worked on an extended basis is pair stock trading, also known as statistical arbitrage.
In 1987, Morgan Stanley announced that it made 50 million dollars on Tartaglio’s team’s automated systems. That was an incredible profit for that era. Although the group was dissolved in 1989, stock pairs have remained one of the pillars of the bank’s strategy. Over time, as details of the strategy reached the general public, stock pairs became one of the most popular neutral strategies around. Today, they constitute the foundation of trading portfolios of professional traders, banks, and funds around the world.
The principle of pair equity trading
The concept of pair trading is surprisingly simple: we find two shares whose price ratio has been stable on a sustained basis and speculate whether it will continue to remain stable. In other words: if the price ratio (stable in the long-term) sways outside of the usual range, we speculate on it returning back to normal after some time.
SMLP – Summit Midstream Partners LP
ENLC – EnLink Midstream LLC
Point 2: The difference between prices is unusually high – you can expect a return to long-term average
Point 3: The prices really became closer again
Abundance of trading opportunities
A stock pair may be made up of any two stock titles. With a view to hedging the risk of the impact of fundamental news (we will talk about this in greater detail in our next article), stock titles from the same sector of the economy are usually chosen. Understandably, a pair comprised of the stock of two companies doing business in the same sector will be better hedged than one comprising the stock of two entirely incompatible companies.
We can easily put together lists of stocks divided by sector, using public resources. Using stock traded on the NYSE and NASDAQ, we can identify from 8 to 140 sectors, depending on the level of detail chosen, comprising some 6500 stocks. Even with the finest resolution (the largest number of sectors), we get 340,000 potential stock pairs!
Pair trading is simple in principle, but it requires very high gross calculation capacity. At one time, one must monitor dozens or hundreds of stock pairs, assess their trading model and execute the relevant orders precisely and flawlessly in the event of a signal for entry / exit. The good news is that there is software available that will do all this work for you. Trading after the initial set-up of the program is not time consuming at all – usually, 10 minutes a day, before the markets close, will do.
Petr Tmej a Petr Slepička
Next chapter: The edge of pair trading, profitability of the strategy