A pairs trading strategy is based on the belief that the market will overreact to news events, press releases, earnings reports basically anything that affects the price of a stock. As the name of the strategy implies, pairs trading involves trading two stocks simultaneously. For a history on pairs trading refer to http://www.investopedia.com/articles/trading/04/090804.asp
Trading Strategy
To set up a pair's trade the trader will look for two stocks that are highly correlated. Thinking of correlation as two lines drawn in the sand helps to visualize this relationship. If the two lines move up and down together perfectly they are highly correlated. Correlation ranges from -1 meaning the two lines in the sand would move in exact opposite directions to +1 being perfectly correlated meaning the lines in the sand would move together.
Johnson & Johnson, Procter & Gamble
Johnson & Johnson and Procter & Gamble exemplify two stocks that are highly correlated. Both of these companies operate in the Consumer Goods sector and both have reached the maturity phase of their business cycle. The correlation coefficient between these two stocks is .43 meaning they are not perfectly correlated. However, they are somewhat correlated and their stock prices should generally move in the same direction.
The opportunity may arise when the two stock prices start to diverge from each other. There are a few ways of identifying when the prices have diverged far enough from each other to present an opportunity. Many pair trading systems will identify the relationship or beta between the two stocks. The system will identify one stock's beta against the others. Beta is simply a measurement of how much stock A will change given a change in stock B. For example after analyzing the relationship between JNJ and PG, I found that PG has a beta of .53 to JNJ. This means if JNJ stock price increases by 1% we can expect PG to increase .53%.
After the strategy identifies the relationship between the two stocks it will analyze the data and come up with some constraints. The system will identify the standard deviation of the relationship between the two stocks. Basic statistics tells us that 95% of the time the relationship should be within 2 standard deviations of the mean, in this case the mean would be the beta.
Profit from Volatility
As the relationship of the two stocks exceeds the two standard deviation threshold, the trader will realize the two stocks prices have diverged from each other too far. The prices have overreacted to something in the market and now it is time for the pair trader to come clean up and hopefully get some profit in return. The trader will identify which way the prices are skewed and enter into a long position in one of the stocks and a short position in the other betting that as the market realizes its mistake the prices will correct and the trader will benefit.
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