Pairs trade

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We closed the previous chapter with a note on Density curve and how the value of the density curve helps us spot pair trading opportunity. In this chapter, we will work towards identifying and initiating an actual trade and learning other dynamics associated with a pair trade.

Just as a reminder — the techniques we have discussed so far in pair trading i. Why not discuss the 2 nd method directly, you may ask — well, this is because I think Mark Whistler method to pair trade lays an excellent foundation and it helps understand the slightly more complex pair trading technique better. The density curve acts as a key trigger for us to identify an opportunity to trade.

I want you to pay attention to the following two things —. You will understand what I mean by this as we proceed. Let us spend a little time on the normal distribution, I pairs trading with options and futures we have discussed this multiple times in the past, but bear with me one more time. The time series data like the ratio typically have an average or mean value. For example, the average value for the ratio time series is 1.

More often than not, the value of the ratio tends to lie around pairs trading with options and futures mean value. If the value of the ratio drifts away from the mean, then one can expect the value of the ratio to gravitate back to the mean.

For example, if the latest value of the ratio shoots up to 2. Now here is a question — If the ratio drifts away from the mean which is bound to happen on a daily basisis there pairs trading with options and futures way wherein we can quantify the probability of the ratio to move back to the mean, again? For example, if the latest ratio value is at 2. This is where the density curve comes in handy.

The value of the density curve tells us how far, in terms of standard deviation, the ratio has deviated away from its mean. Now, if the value is in terms of standard deviation, then naturally there is a probability assigned to it, and eventually, this probability helps us set up a trade.

Here is how you will interpret this data — the 0. How did we arrive at this? I mean what tells us that the ratio of 2. Well, we infer this by looking at the corresponding density curve value i. But How did I arrive at 0. Given the above, if I see the density pairs trading with options and futures value of around 0.

Or if the density curve value is around 0. So, finally, here we are, very close to showcasing our first Pair trade. Few points to remember —. So essentially, a pair trader tracks the ratio and its corresponding density curve value. A pair trade is set up when the ratio and the density curve has deviated convincingly enough from the mean value. This leads us to the next obvious question — what is convincingly enough? Or in other words, at what value of the density curve, should we initiate the trade?

The idea is to initiate a trade either long or short when the ratio is between 2 nd and 3 rd standard deviation and square off the pairs trading with options and futures as it goes below the 2 nd standard deviation. Obviously, the closer it goes toward the mean, the higher is your profit.

On 25 th Octthe density curve value was 0. This is a decent long pair trade set up. Although this does not fall within the preview of a long trade we need the density curve to be between 0. Ideally, we need to stay long and short of the same Rupee value.

We will take the concept of Rupee neutrality to a different dimension when we take up the next pair trading technique. So, once the trade is set up, we now have to wait for the pair to move towards the mean. Ideally, the best pair trade is when you initiate a trade near the 3 rd SD and wait for the ratio to move to the mean, but then this could happen over a long period, and the mark to market could be quite painful. In the absence of deep pockets to accommodate for mark to market, one has to be quick in closing a pair trade.

On 31st Octthe ratio moved up to 1. Hence once can consider closing the trade. Pairs trading with options and futures you notice, the bulk of the profits comes from Axis Bank, this indicates that Axis Bank had deviated away from the regular trading pattern. On 9 th Augustthe density curve printed a value of 0. If you find it confusing to remember which one to buy and sell, think of it this way — the numerator is the dominating stock, so if the pair trade demands you to go long, then buy the numerator.

Likewise, if the pair trade is to short, the short the numerator. Whatever you do with the numerator, the pairs trading with options and futures trade happens with the denominator. Once initiated, the opportunity close this trade occurred on 8 th Sept, yes, the trade was held open for pairs trading with options and futures a month.

The trade details were —. Agreed, once could have waited a bit longer to for the density curve to fall further, but then like I said before, the pair trader has to pairs trading with options and futures a balance between the time and mark to markets.

Again, the bulk of pairs trading with options and futures profit comes from one of the stocks i. I must confess, both the trades did not really fall under the prescribed table giving you the guideline to enter and exit the pair trade.

But like I said before, use the table as a reference and build your expertise around it. Download the excel sheet. Sir about the instrument, when you say buy axis bank or icici, are you referring to the stock or its Futures? It can be done with a combination of futures and spot as well. Will discuss more on this in the following chapters. If i first find correlation between the stocks, then Ratio of the two stocks, Then Average of the Ratio. One can use http: As a request, I would love to get some information on the backtesting part for the pairs trading model.

I can help you with any programming help if needed related to that. I will probably put up the pairs trading with options and futures for programmers. I will do this for the 2nd part of pair trading. Maybe open this up for all, so that everybody can benefit. Hi Karthik, First — your articles are really good for a beginner. We can do pair trade only on futures, as we have to short one of the instruments. Lot sizes are different here, so is it possible that due to that difference, sometimes loss might turn out to be more pairs trading with options and futures profit, if the losing future has significantly higher lot size than the winning one.

Will talk about this in detail as we move forward 4 Nope, when it comes to pair trading, the emphasis is on the price movement, which is captured by futures. Options has many other forces acting on it besides the price movement — like volatility and time. Hi Karthik, You have a natural flair for explaining a complex subject in a very lucid manner, really appreciate you doing it. That said I have a question: Why do the pair trading, just go Long whichever one of the two has deviated the most.

Just a thought………… Keep up the good work. Remember, you are trading a ratio here and not really the stock. A ratio is defined by the stock prices of two different stocks, hence it is mandatory to go long and short at the same time.

If not, this will be a naked position, which can be quite risky. Do we need to keep the number of count of the data to or it should keep on increasing as we add the current data? What is the ideal count of data range to look for ongoing basis? Can we get the complete table of the density curve and the corresponding Standard deviation? You need to look back for at least 1 year, 2 will be great 2 Will try and do that sometime soon.

Will try and put out the entire table, although I pairs trading with options and futures that may not really be required. Hi Karthik I wanna read the all Chapter in Hindi because I am more comfortable in hindi as compare to English, so what to do for this? Please reply me Thanks. Thanks and regards, Samir. That would be tough call, Samir. You will have to identify this — for example, maybe IndusInd Bank and Yes Bank have good correlation.

Happy to see you open this subject for us. And Sir kindly suggest a good software to do all this data collection and calculation. Hi Karthik, Very nice material on Pair trading. Is there any software which provides density curve and other variables mentioned by you?

Sir do you think pairs trading still has relevance in Indian markets? I understand what you are hinting at. The effectiveness of the pair trading really depends upon the way you define pair trading. Most people I know employ simple pair trading strtagies. So are you saying that if the trading system is built with enough intelligence that would provide an edge over other traders?

Sir this was just a thought. Do you think pairs trading can be done between nifty and nifty ETFs? Do you think there are opportunities are there between them?

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The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: This strategy is categorized as a statistical arbitrage and convergence trading strategy. The strategy monitors performance of two historically correlated securities. When the correlation between the two securities temporarily weakens, i. Pairs trading strategy demands good position sizing, market timing , and decision making skill.

Although the strategy does not have much downside risk , there is a scarcity of opportunities, and, for profiting, the trader must be one of the first to capitalize on the opportunity. A notable pairs trader was hedge fund Long-Term Capital Management. Historically, the two companies have shared similar dips and highs, depending on the soda pop market. If the price of Coca Cola were to go up a significant amount while Pepsi stayed the same, a pairs trader would buy Pepsi stock and sell Coca Cola stock, assuming that the two companies would later return to their historical balance point.

If the price of Pepsi rose to close that gap in price, the trader would make money on the Pepsi stock, while if the price of Coca Cola fell, he would make money on having shorted the Coca Cola stock. The reason for the deviated stock to come back to original value is itself an assumption. It is assumed that the pair will have similar business idea as in the past during the holding period of the stock. While it is commonly agreed that individual stock prices are difficult to forecast, there is evidence suggesting that it may be possible to forecast the price—the spread series—of certain stock portfolios.

A common way to attempt this is by constructing the portfolio such that the spread series is a stationary process. To achieve spread stationarity in the context of pairs trading, where the portfolios only consist of two stocks, one can attempt to find a cointegration irregularities between the two stock price series who generally show stationary correlation.

This irregularity is assumed to be bridged soon and forecasts are made in the opposite nature of the irregularity. Among those suitable for pairs trading are Ornstein-Uhlenbeck models, [5] [9] autoregressive moving average ARMA models [10] and vector error correction models. The success of pairs trading depends heavily on the modeling and forecasting of the spread time series. They have found that the distance and co-integration methods result in significant alphas and similar performance, but their profits have decreased over time.

Copula pairs trading strategies result in more stable but smaller profits. Today, pairs trading is often conducted using algorithmic trading strategies on an execution management system.

These strategies are typically built around models that define the spread based on historical data mining and analysis. The algorithm monitors for deviations in price, automatically buying and selling to capitalize on market inefficiencies. The advantage in terms of reaction time allows traders to take advantage of tighter spreads. Trading pairs is not a risk-free strategy. The difficulty comes when prices of the two securities begin to drift apart, i.

Dealing with such adverse situations requires strict risk management rules, which have the trader exit an unprofitable trade as soon as the original setup—a bet for reversion to the mean—has been invalidated.

This can be achieved, for example, by forecasting the spread and exiting at forecast error bounds. A common way to model, and forecast, the spread for risk management purposes is by using autoregressive moving average models. From Wikipedia, the free encyclopedia. This article may be too technical for most readers to understand. Please help improve it to make it understandable to non-experts , without removing the technical details. November Learn how and when to remove this template message.

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