Put Pairs Trading to Work for You - dummies

By David Stevenson

Running a pairs-based strategy (in the UK and around the world) is remarkably straightforward — all you require is a flexible stockbroker willing to offer you the ability to go short a stock, some margin if necessary and access to decent technical charting software.

Step 1: Choose the stock pair

The first place to start is with an obvious set of parallel companies or markets. Competing companies in the same sector make natural potential pairs. Also certain companies have several classes of shares trading simultaneously (for example, common and preferred) that should move largely in unison.

Many big companies are also simultaneously traded on multiple exchanges or have international subsidiaries (for example, Dutch and Royal Shell). Crucially, highly correlated pairs often (but not always) come from the same sector because they face similar systematic risks.

Both common stocks, the stocks most people think of when they hear the term ‘stocks’, and preferred stocks represent a percentage of ownership in a company. With common stocks, shareholders receive dividends, possess voting privileges and have limited liability in the event that the company goes bankrupt.

In a bankruptcy, common stockholders are at the bottom of the ‘who gets paid first’ ladder and can receive company assets only after other creditors and preferred stockholders have been paid. With preferred stocks, shareholders receive a fixed dividend, have no voting rights and, in the event of liquidation, have a higher priority on the company’s assets than do common stockholders.

Moving beyond these obvious candidates, the most basic method is to use some form of quantitative or statistical method. These techniques involve studying historical price patterns to project how well a stock is going to perform in the future. Most traditional hedge-fund managers use what’s called fundamental analysis — systematically analysing industries and companies to find those on the brink of positive, or negative, change.

Step 2: Visually confirm correlation using charts

The Internet is full of great websites that offer state-of-the-art technical charting software, most of which allows you to put the recent share prices of two companies up against each other.

Yahoo! Finance has some amazing real-time charting tools.

Step 3: Create a chart showing the price ratio between the two stocks

A price ratio chart is a line chart of both stocks plotted together, which you calculate by dividing one stock price by the other. These charts measure deviation from the mean (or average spread) between the two stocks in the pair.

Many modern hedge-fund managers looking for potential pairs also use neural networks, which are a new generation of artificial intelligence that simulates the processes of the brain. In a way these technology-based brains are able to ‘learn’ from past experience.

They identify the most likely outperformers and underperformers in a particular sector by looking at variables such as the relationship between the current price and the price in the recent past, and the interrelationship between prices of various shares.