Have you ever noticed how certain stocks in a particular sector or industry tend to move together? When stock A moves up, usually stock B will follow it higher and vice versa when stock A moves down. There are various reasons for this phenomenon we call positive correlation, moving in the same direction. Stocks in similar lines of business and industries tend to move as a group. For example, the two largest casino operator stocks Wynn Resorts Ltd (NASDAQ: WYNN) and Las Vegas Sands Corp. (NYSE: LVS) both tend to move in the same direction, usually lead by WYNN. This can be visualized on any candlestick chart. Fund managers, exchange-traded funds (ETF), traders and algorithm programs are always in and out of these stocks causing parallel fluctuating price moves. When Stock A is rising but Stock B is noticeably falling, this is called negative correlation, moving in opposite directions. Perhaps a hedge fund is unloading a position in Stock B causing a temporary inverse reaction to Stock A. Assuming that Stock B will eventually resume positive correlation back to the normal spread with Stock A, a prudent trader could implement a trading strategy known as Pairs Trading.
Pair trading is a market-neutral trading strategy that seeks to profit on a temporary negative correlation or divergence between two stocks (or futures, options, commodities, markets and ETFs) that are correlated most of the time. In a nutshell, this is a mean-reversion strategy between two like financial instruments. This trade is executed in two parts: Short-selling one stock and Buying Long the other stock. The assumption is that eventually both stocks will eventually return back to their normal trading spread or ratio and positive correlation.
The profits are made when both stocks revert back to the normal positive correlation range. For example, let’s assume WYNN stock is trading up + $4 on the day, while LVS stock is trading down – $2. Normally, if WYNN is up +$4 then LVS stock would tend to be up at least + $1 for a $3 spread or 4 to 1 ratio. Either WYNN is overbought or LVS is oversold causing this large divergence. Assuming these two stocks will eventually revert back to their normal equilibrium levels. You could SHORT WYNN stock when it was up +$4 and BUY LVS stock when it was down – $1. As WYNN peaks and sells off to just + $3, LVS should bounce back to + $1, the normal positive correlation range. This trade would have made + $1 profit on the WYNN SHORT and a + $1 profit on the LVS LONG for a total of +$2 profit per share. Sounds pretty simple, eh? Before you jump headfirst into this strategy, there are five things you need to know first.
1) A Reliable Trading Methodology Is Required Successful pairs trading require solid trading methods that allow one to accurately measure the divergences and properly time entry and exits. The system should be able to indicate over-bought and over-sold price conditions as well as measure support and resistance price levels and differentiate between choppy consolidation and a trend move. The prudence to react and discipline to be selective is key to success. Timing is crucial on entries and exits. A profit can turn quickly into a loss if your system can’t tell you when a stock has bounced to an exhaustion resistance area about to reverse direction back down. Good momentum indicators like stochastic and MACD combined with trend indicators like moving averages are a good starting point.
2) Always Keep a Max Stop-Loss in Place Anomalies do happen. A busted pairs trade can blow out your account especially if the positions are over-leveraged just ask Long-Term Capital Management. Remember that sometimes it is better to dodge than block. The discipline to cut losses and keep stops is the most important attribute for any trader. Losses can compound more than twice as fast if the pairs trade continues its negative correlation. Therefore, it is mandatory to be able to spot when the trade is not working early on. However, a max stop regardless must be in place.
3) Study the Many Ways to Pairs Trade There are so many ways to play the pairs trade. Some traders play purely negative correlation assuming the divergence continues with inverted positions. Seasoned traders will implement scaling techniques on pairs trades with multiple entries and exits to constantly adjust to more favorable average position prices as well as profit on directional trades with alternate sizing. Complex pairs trades are be done across different asset classes. The types of pairs trades are unlimited, so be sure to study up on them to find one that suits your style.
4) Accurate Spread Ratios are a Must The spread can be based on the +/- gains or losses or on actual stock price. It is important to have historical data that confirms the spread ratio. Invest a few days at least of watching the pairs trade as many market climates as possible (up market, down markets, flat markets, etc). There is no substitute for first hand information that you gather from your own observations.
5) Practice on Paper or a Simulator Practice, practice and practice some more. The fault rarely lies with the game plan, but in the execution. The execution of trades for the entry and most importantly for the exit requires familiarity with your brokerage platform. What good is a great entry, if your profit erodes into losses upon your exit? Practice on your broker platform simulator first so you are ready to execute quickly when the window of opportunity arises.
When real money is in play, you will experience a lot of conflicting thoughts and find yourself questioning … well, yourself. Preparation is a must and experience is what will breed confidence. Remember the goal is ultimately to eliminate exposure by closing out your position, hopefully with a profit. Pairs trading can be a profitable strategy for the prepared trader who heeds the aforementioned points.