What is Pairs Trading

posted on July 9th, 2014 by David

davidJonesMyerPairs Pairs trading is a market neutral strategy that involves trading stocks in groups of two (hence the name ‘pairs’).  It is based on the assumption that share prices of companies with similar underlying businesses (Eg: David Jones and Myer) or businesses exposed to common macroeconomic forces, tend to move broadly in line with one another.  The pairs trader is not concerned with each stock individually, but rather the relationship between them.

Pairs traders attempt to identify pairs of stocks that have a high historical correlation, but have temporarily diverged – sometimes due to factors as simple as a short term imbalance of orders or the market reaction to a news announcement.   Assuming there hasn’t been a large fundamental change to either company, there is the expectation that the relationship will revert back to its historical levels.  In order to profit from this relative mispricing, the trader will buy an equal value in the stock they believe to be relatively underpriced, and at the same time sell the stock they believe to be relatively overpriced.  The trader then waits for the relationship between the stocks to revert to its mean before closing both positions.

Pairs Trading has long been a popular strategy of professional traders, hedge funds and investment banks. Due to the intense computational and analytical capabilities required to effectively implement it, it has remained out of reach of the average trader or investor. Through the Bellmont pairs trading recommendation service, private clients can now benefit from detailed analysis, professional advice and real time trading recommendations, enabling them to effectively and simply operate this exciting strategy.

If you already have a trading account with Bellmont you have everything you need to operate this strategy.

Benefits of Pairs Trading

Market neutral strategy – A market neutral strategy is one where there is little or no net exposure to the direction of the overall stock market.  “For example, if the whole market crashes, and the two stocks plummet along with it, the trade should result in a gain on the short position and an offsetting loss on the long position, leaving the profit close to zero in spite of the large move”†.  This means the trader can still find opportunities regardless of broader market direction.

Strong academic results –  A Yale University paper on pairs trading over the period 1963 to 2002 found that pairs trading generated roughly twice the ‘excess return’ of the market index over that period. The paper can be downloaded in the resources section of our site.

Reduced Risk – Pairs trading exposes the investor to significantly less risk than standard directional trading. By taking offsetting positions in similar stocks, a pairs trader removes both market risk and sector risk, however stock specific risk remains.

1. Market risk – Because the trader takes both a long position and short position of equal value, they have no exposure to the direction of the broader market.

2. Sector risk – As the two stocks comprising a ‘pair’ will tend to have similar underlying businesses, the trader usually has minimal exposure to sector specific risks. For example – if a trader is in a David Jones / Myer pairs trade when interest rates are raised – both stocks are likely to fall due to the anticipated impact of interest rates on retail spending. Any loss on the long position should be offset by a roughly corresponding profit on the short position.

3. Stock specific risk – Pairs trading does not remove the risk associated with individual stocks.

Risks of Pairs Trading

Stock Specific Risk – Whilst pairs traders enjoy significantly reduced market risk and sector risk, individual stock risk remains.  One example would be a company that receives a takeover offer.  Generally under these circumstances that stock will rally strongly, but other stocks in that sector are not likely to have similar moves. If that stock is held short in the pairs trade the risk of a loss is heightened.

Pairs Drift – Whilst pairs trades are implemented on the basis of extensive historical analysis and testing that indicates a high probability that the stock prices are likely to return close to their historical relationship, there are no guarantees. Inevitably, some stock pairs will diverge, and it is possible even on a trade of highly correlated pairs to lose on both legs of the trade.

Case Study – David Jones and Myer

In order to illustrate the concept of pairs trading let’s review a case study of two very well know Australian retailers, David Jones and Myer.  Whilst there are no doubt many differences in their operations and target markets, they are both broad-based household retailers and have an overlap in both customers, brands, product categories and as such are exposed to very similar macro conditions.

Overview of David Jones

David Jones Limited (DJS) is a leading upmarket retailer with stores throughout Australia. The Group operates 35 department stores and 2 warehouse outlets. DJS and American Express a in joint venture run a David Jones branded credit card. ‡

Overview of Myer

Myer Holdings Limited (MYR) is one of Australia’s largest department store groups targeting a wide spectrum of consumers. The company has a national network of 67 stores in Australia. Myer retails designer, national, and international fashion and apparel for men, women, and children, and operates a consumer loyalty program. The company focuses on its retail presence and execution, with a mix of house-brand and leased retail space areas. ‡

Charts

The below charts show the historical daily close prices of David Jones (White) and Myer (Green). Note the strong correlation between both stocks.  Pick almost any period on the chart where one stock is rallying and notice that the other stock is generally moving in the same direction.

djs_myr

** Source: Iress Monday 23rd April 2012

Backtesting Results for David Jones and Myer

Backtesting our pairs trading system over a two year period from April 2010 to April 2012 generated 6 trades, all of which were profitable.



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