What is Pairs Trading?

PEPSICO - What is Pairs Trading?

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Pairs trading is a strategy that looks to exploit price discrepancies in the middle of two intimately related shares in order to make a behalf without taking a view of the total direction of the shop and theoretically with only a low risk.

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You may have noticed that there are some shares that move in the same direction most of the time. This often occurs with similar clubs from within the same sector; for example, competitors such as Sainsbury and Tesco. It makes sense that broad shop ups and downs that sway the profitability (and consequently the share price) of Tesco will likewise sway Sainsbury. The share prices of such clubs can be said to be correlated.

Certain events may cause the correlation in the middle of two share prices to breakdown, though.

This could happen because of a logical, fundamental infer (perhaps an economic factor that specifically affects one enterprise but not the other), or it may have more irrational causes, such as trader-sentiment or panic-selling. With pairs-trading, the idea is that irrational factors such as these should only cause a short-term breakdown and that eventually the historical connection in the middle of the two shares will be re-established.

Having made the assumption that a convert in the price-relationship will be temporary, one enterprise can be judged to be 'undervalued' and the other 'overvalued'.

The pairs trader seeks to take advantage of the situation by placing an up-bet on the 'undervalued' share whilst concurrently placing a down-bet on the 'overvalued' share, with the intention of taking a behalf when the price ratio in the middle of the two securities converges back to its historical level.

One of the spread bets is likely to cause a loss, but the aim is for the behalf on the other bet to exceed this amount, providing an total profit.

An advantage of pairs trading is that it takes no view on which direction the shop is heading; instead exit and entry signals are governed solely by the price-relationship in the middle of the two chosen companies. This is known as a 'market-neutral' strategy. As you would expect, in order to remove exposure to the total shop direction, both the up-bet and down-bet need to be equally weighted. 

Some examples of shares that have historically been very correlated, and therefore make convenient candidates for pairs trading, are:

1)    Coca Cola and PepsiCo
2)    Sainsbury and Tesco
3)    Royal Dutch Shell 'A' shares and Bp
4)    Rio Tinto and Bhp Billiton
5)    Yahoo and Google

In order to gauge the suitability of a pair of shares for this type of trading, you need to compare historical price data for the two clubs and invent that there exists a high correlation in the middle of their prices. If you look at the ratio of the two share prices and infer the median (arithmetic mean) price ratio, you can obtain a benchmark which can be used to originate an entry signal (once the price ratio has moved sufficiently from the mean) and a windup signal (when the ratio returns to the mean), as we would expect the price ratio of a intimately correlated pair to return to the mean in time, in case,granted that the contrast from the mean was not a corollary of a permanent breakdown in the price connection of the shares.

The price connection of two shares may constantly breakdown as a corollary of company-specific information, such as a credit-rating downgrade, that affects only one of the two companies.

Consequently, it's important to judge either or not specific news has caused the price ratio to deviate.

It's also essential to keep the exposure to each enterprise balanced, in order to keep the pairs trade market-neutral.

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