When it comes to established trading strategies, Equity Pairs Trading has stood the test of time. This strategy has been used for a number of years by institutional investors such as Julian Robertson at his famous Tiger Fund.
At it’s heart, Equity pairs trading is the concept of taking a view on the historical correlation between two stocks over a period of time. The reason that pairs trading is a favorable trading strategy is because the strategy is largely immune to general movements which impact both stocks as a whole. These include factors such as macroeconomic news that impact on a country or industry group.
What is Equity Pairs Trading?
Equity pairs trading is when an investor enters a trading position by going long one stock and short another. In order for the trade to be successful, the two stocks must be in the same industry and must move in a similar fashion to each other.
When an investor is trading an equity pair, he is trading the “spread”. The spread is the difference between the two stocks. Depending on where the two stocks are, the trader can either go long or short the spread. As the spread expands, the two stocks are moving further away from each other. When the two stocks are moving closer together, this is considered a “compression” in the spread and the pair is said to be “mean reverting”
When the investor expects the spread to continue expanding, he is going long the spread. If the investor expects the spread to compress, he would go short the spread. This spread itself is then monitored and tracked by investors where technical and fundamental analysis is also performed.
Which Stocks to Trade
As trading equity pairs relies on using two companies which are very similar, one will have to look at a number of metrics to find these similarities. These include metrics such as the Market Capitalization, PE ratios and the company’s industry groups among others.
Once the trader has found the two companies that he thinks ideal for pair trading, he should enter the trade as a dollar neutral one. A dollar neutral trade is one in which the same amount of capital is staked on both the long and short side of the trade. This is done such that the purchase of the long shares is paid for by the short sale of the other shares.
Moreover, a dollar neutral trade implies that the investor is only exposed to movements in the spread and not the volatility of the combined pair.
Equity Pair Trading Example
Taking a look at this example, we will enter a trade on two of the biggest payment processors. These are namely Visa and Mastercard. In terms of their similarities, both companies operate in the same industry, have relatively the same size and have a close historical relationship (correlation). This correlation between the two stocks has been about 80%. Taking a look at the below chart, one can see the historical relationship between the two company’s stock prices over the past 200 days.
Visa vs. Mastercard
It is also clear from the above graph that there was a clear diversion in the price of the stocks. Mastercard appears to be performing rather well compared to that of Visa. However, there was not really much reason to justify this. Hence, the investor would hold the view that the theory of mean reversion will take hold and the stock prices of the two companies will eventually come back together. A trader will therefore want to go short the spread or bet on a compression of the spread.
In order to limit any industry or general stock market risk from the trade, the investor should enter a dollar neutral trade. At current prices, Mastercard is currently placed at a higher level than that of Visa. Hence, in order to make it a dollar neutral trade, the investor should purchase 1.3 Visa shares for each Mastercard share that he purchases.
For this example, we will go short 100 shares of Mastercard and go long 130 shares of Visa. With this combination, the investor has a dollar neutral trade and will only be exposed to movements in the spread (as designed).
Taking look at the below chart is the ratio between Mastercard and Visa. What is noticeable is that the ratio has been increasing recently and appears to be at a yearly high. The skilled spread trader will take a look at the spread graph and treat it as if it were itself an asset. They would use standard charting tools to identify the spreads that were likely to compress.
Mastercard / Visa Spread
From the below spread chart, one can see that the ratio now appeared to be touching the edge of the Bollinger bands. This shows that the spread is indeed at possibly unsustainable levels. Another important observation is that the RSI (Relative Strength Index) of the spread is at the overbought levels. Moreover, the volume of the traded spread appears to be decreasing. All of these technical indicators are an indication that a reversal in the spread appears likely.
Potential Risks from Pair Trading
Although the benefits of equity pairs trading are quite evident, there still exits risks with this strategy. Firstly, there is the risk that the pair may take longer than initially estimated to revert and may even continue widening. This could harm a trader’s position and force him to liquidate his holdings. There is even the greater risk is that the historical relationship of the Equity pairs breaks down and does not mean revert.
Similarly, spread trading goes against the norms of traditional trend trading. In that case, the investor will usually go long the stock that is performing well and short the stock that appears to be underperforming.
Using Binary Options for Equity Pairs Trading
Trading an equity pair by going long one stock and short the other can also be done with Binary Options. This means that the trader can enter a CALL option on the stock that he would like to go long and enter a PUT option on the stock that he would like to short. This is a variant of a straddle trade although it is made on two different underlying stocks.
Given the Binary payoff structure of the options, the trader knows at the outset of the trade how much he / she is likely to lose on the trade. This is better than trading vanilla stocks as the investor would then be susceptible to outsized movements in the spread. As mentioned, the investor would also be exposed to a possible breakdown of the relationship and a collapse of the spread. Using Binary Options would limit this risk.