Stock pairs trading

Stock pair trading is a trading strategy based on trading two different stocks at the same time. In pair trading, the investor takes a long position with one stock and trades a short position with the other stock.

In this way, the stocks cover each other and the risk is reduced. In pair trading, we select two stocks with historically correlated (similar, correlated) price movements, usually from the same sector. We assume that their prices are moving in the same direction, but they have moved away from each other (a wider spread has developed between them) and the investor expects the prices to return to similar levels. Thus, one security rises faster and the other slower, or the other security falls. This creates a spread between the two securities. The trader bets on eliminating this spread and takes a long position with the security that has "lagged behind", while "short" the security that has risen faster.

Pair trading is often used by professional traders, for example in so-called hedge funds. Professional traders test a number of potential pairs of stocks. The method used to select stocks for pair trading is called backtesting - it retroactively evaluates historical price data and looks for price divergences - moments when stock prices move away from each other and form a spread. These price divergences are suitable for entering the trade. This is because pairs trading is based on the assumption that divergences are mostly short-term consequences of market inefficiencies, and that stock price relationships will eventually return to average historical values. These divergences are usually caused by temporary changes between supply and demand, reactions to important corporate news, etc.

Statistical methods are used to select pairs, which is why pair trading is sometimes referred to as "statistical arbitrage."

Once an investor has an open pair trade, one of 4 variants can occur:

- The stock he bought (long) goes up and the stock he sold (short) goes down. This is the best option as the investor will make a profit on both trades.

- Both stocks will go up, but the stock bought will go up faster and the stock sold will go up slower. In this case, the long position generates a profit, while the short position generates a loss. However, the profit from the long position is larger, so the total profit is positive.

- Both stocks will fall, but the stock bought will fall faster, and the stock sold will fall slower. The long position results in a loss, but the short position results in a gain. However, the profit from the short position is less than the loss from the long position, so the total result will be a loss.

- In the worst case, the price of both stocks may move against the investor. The stock he bought falls and the stock he sold rises. The loss on this trade is then the largest. Therefore, great care must be taken when selecting stock pairs.

Example: an investor chooses two stocks from the technology sector, International Business Machines (IBM) and Hewlett-Packard (HPQ). In pair trading, it is important that both positions are of equal size - otherwise the trade is unbalanced and the risk of loss increases. In our case, it is about $5,000 per position. A purchase looks like this: On 02/16/2023, an investor opens a long position - he buys 25 shares of IBM at a price of $198/share (total $4950) and a short position - he sells 270 shares of HPQ at a price of $18.5/share (total $4995).

For example, the investor closes the trade on 06/16/2023. A long position on IBM shares was closed after the price increased from $198 to $210; the profit is (210-198)x25 = $300. A short position on HPQ shares was closed after the price fell from 18.5 USD to 14.5 USD. The profit is (18.5-14.5)x270 = 1080 USD. The total profit from the pair trade is 300+1080 = 1380 USD.

Example of a pair trade:

• Coca-Cola and PepsiCo: These two companies are strong competitors in the beverage industry and are often traded together as a stock pair. For example, if Coca-Cola's stock price rises significantly, traders may be interested in selling these shares and buying PepsiCo stock, which is still relatively cheap.
• ExxonMobil and Chevron: This is another example of a pair of stocks in the energy sector. The two companies are strong competitors and often trade together to reduce risk and take advantage of market opportunities.
• Nike and Adidas: These two companies are big players in the sportswear and footwear industry. Traders can trade these two stocks together to avoid the impact of fluctuations in either company and take advantage of market opportunities.

Compared to other strategies, the pair trading strategy is more "hedged" because the positions hedge each other against sector or market risks. If an entire sector collapses, a short position under this strategy minimizes losses. But even this strategy is not without risk.