Pairs Trading – the art of making profits

What Is Pairs Trading?
Pairs trading (also known as statistical arbitrage or spread trading), has the potential to achieve consistent profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss.

The goal is to match two trading symbol that are highly correlated, trading one long and the other short when the pair’s price ratio diverges “x” number of standard deviations (i.e. the zscore). If the pair reverts to its mean trend, a profit is made on one or both of the positions.

How to decide on a good pair trade is explained step-by-step in a easy to understand one-page pic –>

pairs


Click on any pair box to drilldown into more details to analyse it furthur->

pairszoom

NOTE: the Buy/Sell signal above implies for the stock ‘A’


Why Pairs Trading?
Pairs trading is a market-neutral strategy that boasts several advantages:

Controlled risk
Since one position is long and the other short, an automatic hedge is created, so even if market or the sector goes down, the losses on the long position will be offset by the gain in the short position.

Profit regardless of market direction
Another attractive feature of pairs trading is the ability to profit whether the market is going up, down or even sideways. This is because the strategy does not depend on market direction, but it’s the relative performance of the two instruments that determines each trade’s outcome.

No directional risk
Because profits depend on the relative price change between the two instruments, rather than from the direction in which each moves, directional risk is removed.


What are the risks involved ?

No strategy can be without risks, else it would be a money-making machine.

What we are trying to bet on is that if a stock outperforms relative to the other, and they generally have always moved together in the recent past, the underperformer should eventually catch up towards the mean & we could make a profit.

But what if the outperformer continues to outrun the other stock because of some specific news or event in that stock? So we must have stop losses in case the crossing of our SD line continues to break through & run away.

And that is why if you observed in our pic above.. the buy /sell signals which the MYFNO.com app auto-generates are only after the ratio AFTER crossing outside the 2SD lines comes BACK inside the band .


Will suggest you to first get confidence in this concept , by trying out some paper trades before actual venturing into real trading . You can also track the pairs you identify to a favourites Pairslist in the myfno app or even enter dummy trades to track in the its portfolio module. All tools in one app 🙂

So happy pair trading  !!

13 thoughts on “Pairs Trading – the art of making profits

  1. Dear Anurag,
    Have gone thru yr Article, and try and follow the same on your web-site,
    Have following clarifications needed from you:

    1. You have mentioned that when the Graph crosses less than -2SD BUY, and when it crosses more than +2SD SELL, now my point is in a PAIR Trade we BUY one Stock & SELL the other, so what this BUY & SELL SIGNAL means???

    2. You also mentioned that we should Paper Trade a few times and than go for the REAL Trade,
    Now my question to you is that have tried this based on your Charts Signals and one of the Result is as follows:

    The Stocks are [1] Ashok Leyland & [2] Bajaj Auto with CURRENT Signal BUY [1] & SELL [2]:
    Chart Signal says SELL on 15Sep14, with Price of [1] as 42/25 and of [2] as 2,337/50,
    with these Prices the Spread works out to (-) 1,72,562/50 [but as indicated in the Box is 9,783/- why?]

    Now on the next time when on 24Sep14 the Graph Line TOUCHES Mean Line, we should get out of the Trade [as per your Article], on this day the Price of [1] is 39/- and that of [2] is 2399/80,
    So if we had followed CURRENT Advice (BUY [1] & SELL [2]) we would have made a LOSS,
    BUT if we would have REVERSED the Calls Indicated, would have made Profit.

    So do WE conclude that the CURRENT Advice [as shown on TOP of CHART] to be REVERSED when SELL Signal appears on the Graph and follow as it is when BUY Signal appears on the Graph?

    This is needed as the BUY & SELL Signals appearing on this Graphs, may not be alternately?

    All the Best,

    Vipul Kaji

    • Im glad you asked these questions so that others may also be clarified if they have similar doubts

      1. when the app gives a signal ‘Buy’ or ‘Sell’ it applies to the FIRST stock in the pair. i.e. a ‘SELL’ signal in ASHOKLEY/BAJAJAUTO means , sell ASHOKLEY & buy BAJAJAUTO
      2. the spread difference is coming in your calculation because you’ve bought & sold 1 lot each, whereas the app calculates the spread assuming the user has done an equal rupee-value adjusted trade as mentioned in the ‘lots’ ratio, so in this case the price value ratio is approx 0.6 so ASHOKLEY : (11000*42*0.6) – (2330*25). Ideally we should be be showing how much extra shares to buy/sell in the cash market to make equal rupee value trades.. we will add this feature of an optimium adjustment very soon to remove this confusion. Thanks for bringing this up

      Also the signal was a “SELL’ on 15th sept on the “CHART” NOT buy . i believe again the confusion could be because besides the ASHOKLEY dropdown there is ‘buy’ word written, which is actually to indicate that in normal mode for calculation of spread this would be the long stock . SO in this case ‘FLIP’ should be clicked before saving to portfolio. So as of now the ‘CHART’ should be seen for the signal . WIll work on a clearer presentation of the stock pair when zoomed in.

      Also please note, the spread value is as good as the value of the pair long stock 1 & short stock 2… so if you sell its as good as you’re selling higher value & want the spread value to reduce to make profit

  2. sir,
    i am pair trader from last 5 years i dont find any tool in your sites to trade between more than 2 stocks and adding our variables to stock prices to find pair trades. i want to make my ratio by multiplying my multiplier to stock prices and also want spread charts of this value that i multiply/divide in one stock and then subtracting it from another by multiply/divide another value to stock prices .

    please help

    amit

  3. Dear Anurag,
    In this reply you have given last minute clarifications and suggestions end have said that in this next updates these clarifications mentioned would be elaborated further.you have also asked to use Flip without any reason and nowhere in your explanation mentioned how to use flip.
    Thus if someone with faith in your writeup buys your services to generate calls from pair trading and executed trades would loose his capital.
    Thus you should have been vigilant enough to cross check your strategy and its explanation perfectly before bringing it to people at large.
    Hpe you will take this comment in constructive way.
    C.n.vishwakarma
    Cnvishwa@yahoo.com

    • Dear Vishwa,
      Thanks for the frank feedback
      Just to extend on the explanation –> now instead of the FLIP button we directly have a Buy/Sell button .. meaning to Buy/Sell stock A and if you click that button again it gets flipped.. so A comes on denominator & B the numerator, but essentially position remains SAME.

      NOTE : Flip is not closing out or reversing of the position, it is just for denoting that Stock A is buy or sell & the stock B is thus the opposite.
      Also the ratio is now clarified as A:B ( instead of a decimal) i.e no. of A lots to no. of B lots, to come closest to equivalent money value

      see attached image of these 2 new fundas ->

      Pairs

    • right now we have mentioned the no. of lots and the shares in each litsize also.. to have an exact no. of shares to match exact value, we will try and add this feature in our roadmap

  4. Dear Anuraag,

    At the out set, Thanks for making thing easy for pair traders!

    Fundamentally you are using correlation as a base to select good pairs, as I studied co-integration is better choice for the same!!

    Kindly share your thoughts on the same.

    Dhadiga
    NY

    • Hi … after chking out some articles/videos.. i too agree on your point .. will look forward to adding this measure also in the near future to have an overall edge while making a pairs decision. Thanks for the suggestion.

      • Dear Anuraag,

        Thanks for acknowledging.. kindly let me know once you are done with incorporation of all above conditions that are considered by you! I will be happy to afford a yearly subscription!

        Thanks
        Dhadiga
        NY

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