Pairs trading 102 (How to pick potential pairs)
Pairs trading is when you buy one security and sell short another. For a more in depth look at pairs trading, check out my article called Pairs Trading 101. While using this strategy there are many possible objectives and outcomes. The methodologies I employ most often are relative outperformance and mean reversion. Relative out performance means you expect the security that you bought will increase in value more than the security you shorted. Mean reversion is when you expect that two securities that are unusually far apart, or that are momentarily uncorrelated, to return to normal.
For any pairs strategy the securities must be highly correlated. Looking at a chart of two securities, their movement should mirror one another. Highly correlated stocks normally go up together and go down together, although the magnitude of these moves may not be the same. A final note on general pairs trading parameters, a strong pair today, may not be a strong pair tomorrow. Earnings, company announcements, and company specific events can destroy or create a successful pairs regime.
Before embarking on a pairs strategy you must ensure that two stocks are highly correlated and that their chart’s mirror one another semi-closely at least. Starting with relative out performance, this strategy is best implemented in a few main scenarios. One of my favorites, is picking two stocks in the same industry, looking at financial ratios like P/E, EV/EBITDA, ROA, leverage, coverage, as well as using news and trends to find a stock I believe will out perform another in that same industry. I buy the stock I expect to outperform and short the stock I expect to under perform. Another way to do this is to use indices. For example HYG tends to outperform LQD during periods of economic prosperity. The benefit of this, as I explained in Pairs Trading 101, is that in a pairs trade, you are not exposed to the industry that you are investing in. If positive news comes out for semiconductors, and you bought one and shorted another, the gains will mostly be canceled out. Thus pairs trading can minimize risk while establishing a systematic trading methodology.
Mean reversion, is best implemented when you find stocks that have been highly correlated and deviated to some degree. When looking at a deviation there are two main factors to consider- how large of a deviation and why the deviation happened. If a move is too large, and the event that caused the move is something that could alter long term performance, these factors could make the stocks become uncorrelated. For example, a lucrative contract, an acquisition, extreme earnings results, and other game changing factors like these make poor pairs trading indicators because these factors will change future performance for one stock. The ideal mean reversion would be if two stocks deviated without a major indicator, because you would obviously expect things to return back to normal. So, you short the “over-valued” and buy the “under-valued”. One thing to keep in mind with mean reversion is that it will take more research to learn about entry and exit points. Also while using this strategy, you will often take losses in the beginning because you are speculating that the trend will reverse, and this will likely not happen immediately.
For more pairs trading ideas check out my invstr page @robbieb.