Traders often encounter the term “risk-free trading.” Although achieving a genuinely risk-free strategy is virtually impossible, certain approaches can indeed be described as having less downside risk than others. Pairs trading unequivocally falls into this category.
Pairs trading involves selecting two correlated financial products or groups of products, determining their historical correlation, and assuming that this correlation will persist in the future. Essentially, a trader is speculating that, more likely than not, this correlation should endure. With proper knowledge of position sizing, a skilled trader can effectively incorporate pairs trading concepts into their day-trading strategies.
Benefits of Pairs Trading
Pairs trading offers several advantages, primarily shielding the trader from market-wide sources of risk. A market-neutral pairs trading strategy can safeguard against market-wide fluctuations. For instance, if two stocks exhibit a high correlation, a trader can sell the outperforming stock and buy the underperforming one. Believing that their relative correlation will revert to normal, the trader hedges against market-wide movements. When the stocks eventually regain their historical proportion/correlation, the trader can close both positions, securing a profit.
Here's a basic example using the daily closing prices of Reliance Industries and Essar Oil for the past 7 trading days:
| RELIANCE | ESSAR OIL | Ratio |
| 765.35 | 63.35 | 12.08 |
| 771.2 | 64.4 | 11.98 |
| 765.85 | 64.85 | 11.81 |
| 773.75 | 66.05 | 11.71 |
| 773.65 | 68.25 | 11.34 |
| 786.8 | 68.2 | 11.54 |
| 798.3 | 69.8 | 11.44 |
| Correlation | 87.21% | |
The correlation can be easily calculated in Microsoft Excel using the CORREL function.
Given the high correlation between the two products, a trader may deduce that the ratio between the two products should fall within the range of 11 and 13. If, for instance, Reliance is trading at 800 and EssarOil at 73 the next day, with a calculated ratio of less than 11 (800/73 = 10.95), the trader perceives this as a favorable opportunity. In this scenario, the trader would sell Essar Oil and buy Reliance since Reliance is relatively underperforming, and Essar Oil is overperforming. The trader, following the ratio of approximately 11, would sell 11 shares of Essar Oil for every share of Reliance purchased.
The critical juncture for the trader is deciding when to exit the trade. Patience becomes the most challenging aspect of trading. Ideally, the trader aims to exit the trade once the ratio stabilizes above 11, yielding a profit. Setting a profit objective (and a stop-loss if possible) upon entering the trade is generally advisable. In this example, the trader might set 13 as the desired ratio for exiting the trade.
Observing that Reliance is now trading at 760 and Essar Oil at 58.45, breaching the ratio of 13, the trader promptly sells Reliance and purchases Essar Oil.
If the trader executed 110 shares of Essar Oil and 10 shares of Reliance, the net profit (before costs) would have been:
EssarOil: (73-58.45) x 110 = ₹1600.50 profit
Reliance: (760-800) x 10 = ₹400 loss
Net: ₹1200.50 profit
Despite a market drop between the two series of transactions (both Reliance and Essar Oil falling in price), the trader profits by hedging their trades. This exemplifies the power of Pairs Trading.
Getting Started
Pairs trading, in its simplest form, involves calculating the correlation between any two single financial instruments. Similar to the above example, a trader can apply the concept to Cash-Futures arbitrage by comparing the near-month futures product of a security against its Cash underlying.
Key concepts to remember:
Ensure Intuitive Correlation: Make sure it intuitively makes sense for the two products to be correlated. Correlation in data does not imply causation.
Use a High Sample Size: Utilize a significant sample size to calculate correlation, ensuring a steady, consistent correlation over many months.
Proper Position Sizing: Implement proper position sizing to ensure the market value of the two transactions is as close as possible.
Profit Objectives and Stop Losses: Set profit objectives and stop losses based on hard prices or ratios to trade emotion-free.
Conclusion
Pairs Trading can be a highly effective way to hedge risks while trading, eliminating market-wide risks and allowing traders to remain market neutral. While individual trade profits may not be substantial, downside risk is minimized, providing peace of mind. With diligence, proper position sizing, and patience, Pairs Trading can effectively hedge risks in various market conditions.