What is Pair Trading?

Investing in securities involves a combination of thorough technical and fundamental analysis. Often, traders rely on various technical tools and strategies to gain higher returns from the market. Such tools and strategies are determined by analyzing historical data and trends. However, identifying short to intermediate-term strategies proves to be challenging.

Pair trading was introduced in the mid-1980s by a group of technical analysts at Morgan Stanley. Over the years, it has gained importance among individuals, institutions, and hedge funds. Pair Trading in India has been revolutionized with the advent of technology where algorithms and BOTs help identify opportunities for pair trading. Let’s break it down further.

What is Pair Trading?

Pair trading involves undertaking a long and short position in stocks that have a high correlation. A relatable example of pair trading can be compared with an interstate highway and service road.

Generally, the main highway is a long, concrete road whereas the service road runs parallel to the highway on either side. The service road provides access to shops, houses, farms, commercial and industrial areas along the highway. Both roads run parallelly on either side. If the highway is inclined in a particular direction, so is the service road. The path followed is similar except for minor obstructions on the service road, which could be a tree or a pole.

Pair trading works in a similar way where the stocks you purchase belong to a similar industry but different companies or brands.

Various attributes of pair trading

The features of pair trading when correlated to the example mentioned above include:

1. Securities

   The highway and service road are securities in which you can invest. Let’s consider Stock A & B.

2. Relationship

   The relationship between the highway and service road depicts the relationship between Stock A & B. Market impact on Stock A will be similar to that of Stock B. Both stocks behave similarly.

3. Relationship deviation

   Similar to obstruction on the service road, there may be events that will lead to breaking in the correlation between the stocks.

4. Impact of deviation

   The deviation in correlation tends to be short-lived and the stocks promptly recover their relationship.

Let’s consider two companies – Hero MotoCorp and Bajaj Auto:

1. Both are private companies in the automobile industry in India.
2. Both have similar products, target audiences, and customers.
3. Both have similar volumes, presence in India.
4. Both face similar challenges, regulations, and constraints.

Both are highly correlated. Thus, a change in market conditions will have a similar impact on both companies. For example, an increase in the price of fuel will have a negative impact not only on the industry but also on the companies. Considering everything else to be equal, if the stock price of Hero MotoCorp moves in a particular direction, in all probability, the stock price of Bajaj Auto will also move in the same direction.

However, if the stock price of the two companies does not move in the same direction, this is the ideal trading opportunity. Herein lies the crux of pair trading. Therefore, pair trading usually revolves around the following strategies:

1. Identifying the relationship between stocks

   Many investors will look for securities in the same sector or industry group. The correlation between companies in different sectors tends to be lower. For example, a change in the raw materials required for automobiles will have an impact on Hero Moto but not on HDFC bank.

2. Analyzing the correlation between the stocks

   A correlation of 0.85 is considered to be adequate while entering into fair trade. Hero Moto and Bajaj Finance have displayed a correlation of 0.87 over the last year.

3. Tracking the correlation daily

   Correlation refers to the degree to which two variables are dependent on each other or move in coordination with one another. The correlation coefficient ranges from -1 to 1. A correlation of -1 indicated that the securities have a perfect negative correlation i.e. if one increases by 50% the other falls. A value of zero means there is no correlation and a value of 1 means there is a perfect positive correlation.

4. Checking for anomalies in correlation

   Lastly, one has to identify opportunities to trade. Tracking the deviation in the correlation helps to access opportunities for trading. These may be intraday or long-term

What is pair trading in the stock market?

As discussed above, an anomaly in correlated securities provides a trading opportunity. The reason for anomalies in prices could be a result of various factors such as excessive speculation in trading, the announcement of quarterly results, changes in top management, etc. A pair trading strategy essentially involves identifying such anomalies and executing a long position in one and a short position in the other to benefit from the temporarily weakened correlation. The idea is to take benefit of the temporary deviation in correlation assuming that the gap would recover to its original state.

In stock pair trading, a long position is to be executed for the underperforming security and a short sell for the outperforming security. If the securities return to their original correlation, that’s where the profit lies. Thus, the entry and exit points in a pair trading are clearly defined.

To illustrate the potential of profit from pair trading, consider two securities – ICICI Bank and HDFC Bank which historically have a high correlation of 0.95. RBI issues guidelines to HDFC Bank concerning issuing credit cards. Consequently, the price of HDFC Bank falls sharply and the correlation between the securities reduces in the short term to 0.50. In this case, the trader will take a long position on HDFC Bank and short sell ICICI Bank. With time, the price of HDFC Bank recovers, and the correlation between the two securities is returns to 0.95. The trader benefits from the long position and the closed short position.

Advantages of Pair Trade

The primary benefit of pair trade is risk mitigation. Contrasting trades are executed for securities with similar correlations. Profits are realized when the underperforming security regains value, and the outperforming security deflates.

However, to leverage profits from pair trading, the securities must be correlated at all costs. The correlation between the stocks must be a minimum of 0.80. However, it is difficult to identify such securities.

Final Word

To conclude, pair trading is often categorized as a market-neutral strategy because the stocks are long and short at the same time. This theory is flawed since the contradictory positions are held on two different stocks. It is pertinent to note the risks involved in pair trading and the purpose is to benefit from the relative values of both securities. Equity experts at IIFL can help you understand the risks and benefits, making them the perfect advisors on your journey through stock market trading.