1 1.1 2 2.1 2.2 2.3 3 4 4.2 4.3 4.4 4.5 4.6 4.7 5 6 6.1 6.2 6.3 7 8 Introduction
Equity Market Neutral Strategy Pair Trading Key Characteristics Instruments Used Benefits of Pair Trading Strategy Pair Trading Model Screening Pairs Trading Rules Trading Period Excess Return Computation Strategy Profits Risk Control Steps in Pair Trading Cases of Pair Trading Punjab National Bank – Bank of India Aban offshore - Shiv-Vani oil & Gas Exploration Punjab National Bank – Bank of Baroda Conclusion Bibliography
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This project links uninformed demand shocks with the profits and risks of pairs trading. Usually employed by sophisticated investors, pair trading is a relative value strategy that simultaneously buys one stock while selling another. In a market with limited risk bearing capacity, uninformed demand shocks cause temporary price pressure. A pair of stock prices that have historically moved together diverge when subjected to differential shocks. Uninformed buying is shown to be the dominant factor behind the divergence. A strategy that sells the higher priced stock and buys the lower priced stock earns returns in excess of the market. The marked-to-market returns of a pairs trading strategy are highly correlated with uninformed demand shocks in the underlying shares. Measuring pairs trading profits represents a concise way to quantify the costs of liquidity provision (i.e., the costs of keeping relative prices in line.) It introduced to me strategies like risk management in convergence trading and understand the importance and implications of such strategies as market neutral strategies. It provided me a rare opportunity to understand importance of various statistical tools in the world of investments. strategies like pair trading explore the temporary mispricing between assets and develops a framework to take advantage of this temporary mispricing. Market provides opportunities and it is individuals who should look at this opportunity in correct perspective. Pair’ trading is useful in markets full of uncertainty.
Pairs trading is a type of relative value strategy that buys an overpriced security and simultaneously sells a similar, underpriced security. Traders typically track a pair of securities whose prices move together. When prices diverge, they buy the down stock and simultaneously sell the up stock. Traders profit if prices converge but lose money if prices diverge further. Pairs trading has generated hundreds of millions of dollars in profits for companies such as Morgan Stanley and D.E. Shaw. Studying pairs trading broadens our understanding of financial markets. Because pairs trading entails risk taking. Profits need not be thought of as coming from a narrow Wall St. strategy. Rather, readers can think of these arbitrageurs as playing a vital role in the relative pricing of securities. Profits are compensation for performing this service. Equivalently, readers can think of profits as compensation for providing liquidity during times of differential market stress (e.g., stresses that affect some stocks but not others.) Surprisingly, relative value strategies have received little attention in the academic literature. The most notable paper is by Gatev, Goetzmann, and Rouwenhorst (2003) and offers a comprehensive analysis. The authors use daily US data from 1962 to 2002. They show a simple pairs trading rule produces excess returns of 11% per annum. Returns have high risk-adjusted alphas, low exposure to known sources of systematic risk, cover reasonable transaction costs, and do not come from short-term return reversals as documented in Lehmann (1990). It is observed that uninformed trading shocks can explain the profitability of pairs trading. Second, and much more importantly, we link uninformed trading shocks to the profitability of pairs trading. We show that uninformed net buying is significantly correlated with a pair’s initial price divergence. Additionally, uninformed trading is a significant “factor” in explaining the strategy’s marked-to-market returns. These results suggest that pairs-trading strategies are profitable because they identify situations with temporary price pressure. The strategy has low risk because a position is effectively hedged by an offsetting position with similar factor
The goal is to profit from relative miss pricings between related instruments—going long those that are perceived to be under priced while going short those that are perceived to be over priced—while avoiding systematic risk. but a properly executed pairs trade is dollar-neutral. By maintaining a market-neutral position. Consider the following comparison of a spread trade vs. Market neutral strategies are sometimes called relative value strategies. the effects of market direction can be largely eliminated from the trade. spreads Many traders think of a pair as a “spread” trade. Pairs trade Long 100 shares of Stock A: 2.loadings.000) This is a hedged.000 Short 100 shares of stock B: 1. A trader goes long certain instruments while shorting others in such a way that his portfolio has no net exposure to broad market moves. bullish position. A spread trade creates either net long or net short exposure. Execution is simplified and costs kept to a minimum because the offsetting position is limited to a single stock. a pairs trade: Stock A: 20 per share Stock B: 10 per share Spread trade Long 100 shares of stock A: 2.000 Short 200 shares of Stock B: 2. Market neutral strategies are trading strategies that are widely used by hedge funds or proprietary traders.000
.000 Net long: 10 per share (1. Pairs vs. but this comparison is not quite accurate.
e. if both stocks dropped by 5. Scenario 1 Both stocks rise 50 percent. however. the specifics of either stock had no effect on price — the entire move is explained by the broader market fluctuations. while Stock B loses 50 percent). and the pairs trade is flat (Stock A’s 1. Equity Market Neutral: An Overview There are numerous strategies that generally fall under the market neutral umbrella.000 profit . the spread trade loses 500 (Stock A’s 1. one stock performs better than the other). They are deemed market neutral because the direction of a particular market. Market neutral strategies are designed to benefit investors in all market conditions.000 loss Stock B’s 500 profit) as the pairs trade stays flat.000 loss).000 profit Stock B’s 500 loss). the spread trade loses money despite both stocks dropping by an equal percentage. Stock A: 10 Stock B: 5 A spread trade is a market bet with a built-in hedge. Similarly. whether up or down. The trade must be market-neutral to ensure it won’t lose money unless there’s a change in relative performance (i. the spread trade gains 500 (Stock A’s 1. In the first scenario’s bull market. In the second scenario’s bear market. should bare
. A trade can only capture this relative performance if the trade is neutral. In both scenarios. Stock A: 30 Stock B: 15 Scenario 2 Both stocks fall 50 percent. Here. while a pairs trade is a market-neutral position. the spread trade would remain flat even though Stock A outperformed Stock B (Stock A loses 25 percent.Stock B’s 1.Net long/short: 0 This is a true market-neutral position.
The idea behind short-selling is to buy these same shares back at a future date for a lesser price and replenish what was borrowed from the broker. the manager determines what companies are suitable for buying. unlike the long portfolio. Share prices of competent companies have a tendency to increase faster than that of weaker companies. most of the companies go up in price. A market neutral manager in this case will go long on the competent companies and short-sell the weaker companies in the same sector. A market neutral manager will utilize such negative information by short-selling the stock and positioning it in the portfolio to reduce volatility. the elements of an underlying stock market should have no bearing on the portfolio returns. If an underlying company does not meet the manager’s stringent purchasing requirements. The first comes from the long side of the portfolio. The same holds true during declines. Risk is mitigated through a consummated relationship between the long and short positions in the portfolio. An equity market neutral strategy warrants more efficient use of information. Such strategies include convertible arbitrage.
. Equity market neutral. Profits are generated if the stocks in the short portfolio decrease in price. If the sector rallies. There is generally a price correlation between stocks in the same sector. involves the trading of securities that are interdependent. as opposed to calling a market direction. merger arbitrage and equity market neutral.little or no impact on the ability to generate a return. At this point. Profits are generated when the stocks in the long portfolio rise in price. If constructed properly. The objective is to generate a return without taking significant directional bets. companies are selected through a very sophisticated process but. Once again. also known as statistical arbitrage or pairs trading. The second way to profit in an equity market neutral strategy is from the short portfolio. Diversifying across the entire market breadth while pairing equal long and short positions within the same sectors provides for a statistical advantage. Through a sophisticated process. those particular shares are borrowed from a broker and sold to generate the short portfolio.There are potentially three sources of returns in an equity market neutral strategy. the company is passed over and the information is discarded. Long-only mangers look at companies and purchase their stock with the anticipation that the share price will increase in value. the manager looks for statistics that would suggest that the share price of a company is unattractive. fixed income arbitrage. The manager is concerned with capturing a return through the spread of the long and short positions.
This is known as the short rebate. equity market neutral is not infallible. The portfolio is turned over often. Style drift can often creep into the construction and management of an equity market neutral portfolio. producing very different returns and levels of volatility. If investors run up the stock price and reward companies that would generally be deemed inefficient. providing a balanced and diversified portfolio. not all stocks can be shorted. The stock selection criteria can vary from manager to manger. Managers will short stocks that have a higher degree of liquidity.The third source of returns in the equity market neutral strategy comes from the proceeds of the short sale. The strategy by nature is extremely complex. Managers are occasionally affected by the way the markets will value stocks as a whole. Managers will try to identify such a trend and compensate by reversing the shorts and establishing long positions on the inefficient companies. Notably. There are several concerns with which managers are faced. Simply put. but are chosen to form a codependent relationship. As with any investment strategy. As a result of the short positions. returns are independent and uncorrelated to market direction. Trading within an equity market neutral strategy can be very costly. a majority of the short positions in the portfolio could be perversely affected. The quantity of stocks obtainable for shorting may be limited. Sophisticated and expensive computer models are used to analyze data and assist in determining long and short positions for the portfolio. This can present capacity issues within the portfolio. There are tremendous advantages to having an equity market neutral style in an investment portfolio. trading is usually double that of a long-only portfolio. Volatility is usually low. Keep in mind that stocks in the long and short portfolio are not randomly selected. Another concern is the limited availability of stocks for the short-sell. cash is raised from the proceeds and is typically reinvested in T-bills. to rebalance the long and short positions. Equity market neutral strategies often complement other investment strategies. Returns are often attractive and constant regardless of market or economic downturns. The emotional propensity or bias toward a specific sector or stock can lead to increased
. When the manager sells the stocks that were borrowed from the broker.
The benefits definitely outweigh the pitfalls. (the difference between the long and short positions in the portfolio).
. Managers struggle to maintain a relatively small net exposure.Despite these obstacles. equity market neutral strategies have performed exceptionally well over the last ten years. equity market neutral strategies are well suited for today’s hostile investment environment. With the ability to generate an absolute return coupled with low volatility.volatility.
where we believe one stock will outperform the other one in the short term. The objective is to make money on the relative price movements between them. while short selling the overvalued security. The two stocks might both go up. Gains are earned when the price relationship is restored Pair trading is a non-directional. constant price ratio) will have so in the future as well. and the other half of the pairs trade may lose money. thereby maintaining market neutrality. relative value investment strategy that seeks to identify two companies with similar characteristics whose equity securities are currently trading at a price relationship that is out of their historical trading range. but the stock you are short will drop more and faster than the stock you are long. This implies that we will try to find shares with similar betas. which can be exploited. If there is a deviation from the historical mean. this creates a trading opportunity. The investment strategy we aim at implementing is a market neutral long/short strategy.e. Pair of stock prices that have historically moved together in a correlated manner. but the goal is for the profits to exceed the losses. but the stock you are long will go up more and faster than the stock you are short. that is.
. The starting point of this strategy is that stocks that have historically had the same trading patterns (i. position on such a pair when its components diverge and unwinding the position when they next converge has existed since the early periods of stock trading. Or. a long (bullish) position in one stock and another short (bearish) position in another stock. One half of the pairs trade may be profitable. the two stocks might both go down. diverge when subjected to differential demand shocks. This investment strategy entails buying the undervalued security. By simultaneously taking both a long and short position the beta of the pair equals zero and the performance generated equals alpha.PAIR TRADING
Pairs trading refers to opposite positions in two different stocks or indices.
the label is applied to anything that could be considered. A market-neutral strategy derives its returns from the relationship between the performance of its long positions and its short positions.Key Characterisitics This definition lays out three main areas of focus that play out as subtexts to the overall idea of pairs trading and must be considered and understood before the unified strategy will make sense: Market neutrality. The pairs system is essentially an arbitrage system that allows the trader to capture profits from the divergence of two correlated stocks. When pair trading involves trading two correlated stocks. even loosely. Many investors mistake the term to mean “risk free”. long position should make money. something that reduces market exposure or systematic risk. sell short one stock while simultaneously buying the other. Market neutrality is the first of the three major features of pairs trading selected for investigation. Of course. while each side the trade is making money. regardless of whether this relationship is done on the security or portfolio level. The position has “hedged” itself to the market and therefore the market is free to do what it wants. The term “market-neutral” has come to be a quite appealing label in the last several years and can refer to a wide variety of strategies. A careful pairs trader will perform several layers of analysis on top of the model output before any pairs are actually executed While it is certainly possible to create fundamentally driven pairs trades.
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. relative value or statistical arbitrage and technical analysis. This misconception has been narrowly focused on in the marketing of these types of products. and. fundamentals are used simply as an overlay to ensure that there is no glaringly obvious reason to avoid a trade not captured in the technical indicators examined. there’s the other side that is losing money. Pairs trading contain elements of both relative value and statistical arbitrage in that it often uses a statistical model as the initial screen for creating a relative value trade. the methodology suggested uses technical to perform the majority of the analysis required before trading. If it goes up. If the market goes down. often. the short position should make money.
then if stock B moves up 1%.
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. A technique that doesn’t rely on more sophisticated statistical tests is to look at a range of dates for the calculations. say 30 days. 60 days. Covariance is a measure of the tendency of the two stocks or indices to move together.00 change in the stock price. That means 200 shares of stock B are needed to have the same potential risk/reward profile as 100 shares of stock A. In trading terms. The beta indicates the magnitude of the relationship of the independent variable relative to the dependent variable. The correlation calculated using six months of daily data will almost certainly be different from the correlation and beta calculated using three years of monthly data. and the other stock’s percentage returns is set as the dependent variable. In the regression. the more possibility that the two stocks or indices will continue to have that relationship. Beta is another tool used in pairs trading that predicts the behavior of one stock based on information about another stock. It is a coefficient that measures the magnitude of the relationship between two stocks or indices and is calculated with a linear regression model. Beta is used to determine how many share of each stock to execute for the pairs trade. For example. and dividing the covariance by the standard deviations sets the correlation between +1 and -1. Beta is usually displayed as the percentage that a stock moves against a particular index. you can apply beta to the delta of the positions to determine the quantity for each stock in the pair.00 relative to stock B. and 120 days and see how similar the correlations are between them. beta indicates how much a stock will move when another stock or index moves 1%. The question when measuring the correlation coefficient between two stocks is about how much data to use. then stock A is expected to move up 2%.Correlation is calculated by dividing the covariance of the percentage changes of each stock or index divided by the product of the standard deviations for the two stocks. if stock A has a beta of 2. 90 days. The more similar they are. Because beta measures the magnitude of the relationship between two stocks or indices. Remember that delta is an estimate of how much an option will change in value for a 1. A good starting point is to use the correlation for approximately the same number of days the stock is expected be held for the pairs trade. the set of one stock’s percentage returns is set as the independent variable.
Between the STOCKS b. and can simply be used as stock substitutes: long calls for long stock. Options also usually have higher “slippage” in execution than stocks do. Between the STOCKS and OPTIONS Stocks are relatively easy to execute in actively traded stocks. That is. and the deltas can be roughly equivalent in the pairs positions. you can lose a lot of money on both the long and short stock positions of the pairs trade. one should try to have roughly the same dollar amount of risk between the positions. Options are a good vehicle for pairs trading. Option spreads have many advantages.That way. such as limited risk and reduced exposure to gamma. I use stocks only when I am highly confident in the trade. They can also used to create situations where you can still profit if the spread between the pairs trade does not move the way you expect it will. trades that will give you the correct relative exposure can be found. if you expect that a spread between two stocks will revert to a mean. such as time decay and exposure to drops in implied volatility (vega). That is. but if it does not. buying options has its own risks. Between the OPTIONS c. When looking for strategies comprising the pair. probable gain or loss of roughly the same amount between the two verticals. and vega. Once it is determined that how many deltas are for each stock or index of the pairs for trade. but can be tougher to execute quickly. The reason for doing this is to have the ability for one half of the pairs trade to make or lose as much as the other in the event that the pair does not move in the way
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. Options have limited risk. theta. Instrument Used for Pair Trading Pair trading strategy can be used a. long puts for short stock. Also. but have virtually unlimited risk if you’re wrong. one is not significantly riskier than the other.
Benefits of pair trading What can Pair Trading do for You?Are you tired of trying to guess the market’s direction? Would you like to learn how our professional traders have been consistently taking money out of the market? Are you looking for a new strategy that can make you money and help minimize the risk? Then pair trading may be perfect for you! Our pair trading method opens the door to multi-layered trading strategies. that is. When you study the price action of a pair you get very powerful results. All this helps with a trader's confidence. Adjust the trade quantities to make the risk/reward of the long and short verticals equal. Such a position could be considered to have equal risk and reward between the two verticals. That is. there is a potential profit to balance the potential loss. If both the long and short verticals reach their minimum values. Spread trading is trading instruments that are by design quite prone to range bound trading.00-point wide vertical and buying a 2. The chop can be easily recognized.expected. in both cases where the pairs of stocks or indices make extreme price moves. Thus. The limited risk characteristics of vertical spreads provides a natural “stop” for the pairs trade.00-point vertical.00-point verticals reach their maximum value. for example selling a 5. or moving fast or slow. facilitates diversification as you can trade many pairs at a time. incurring a debit upon execution. selling a 2. and allows you to potentially trade larger. as long as the long vertical’s profits exceed both the loss on the short vertical and that initial debit. the profit of the long should offset the loss on the short 2. a credit is preferable. orders enveloped around the bids and asks of the pair stocks to participate in great
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. Whether the market is traveling up or down or sideways. The initial credit allows for extreme moves in the spread and still provide the potential for profit. In a very large move in both underlying stocks or indices.00-point vertical and the initial debit. If both the long 2. buy two 2. So. the trader can generate profits from trading the differential of two correlated stock any and every day. the profits on the long vertical are potentially greater than the loss on the short.50-point verticals and sell one 5.50-point and short 2. When paying for a pair trade. When the sides of the pairs trade are of equal risk and reward.00-point vertical and buying a 5. the loss on the pairs trade is restricted to that minimum debit.00-point vertical. For example. it is better to have one side to be able to make more money than the other.50-point wide vertical. a small debit is acceptable.
Consequently.prints. A pair trader actually gets to respond to the action that the market is providing. not exposed. as you would be by a long position only. recognizes patterns and participates in a market neutral manner. Many of the books written during the bubble phase of the market in the 90's focus on trading momentum during volatility and predictable order flow. The markets have changed radically in the last six months. and the options available to the trader increase. Frequently. a trader who focuses on trying to predict the overall market direction or the direction of a single stock is often disappointed. with predictability increased. the exact opposite outcome of what you think will happen. the risk is reduced. becoming largely random with only brief periods of order. Also. and offer little help in consistently extracting profits in the current market climate.
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Free resources invested in risk-free interest rate. Testing for the mean reversion The challenge in this strategy is identifying stocks that tend to move together and therefore make potential pairs. Summary: . Research has shown that if the confidence level is relaxed. This implies that a very large number of regressions will be run to identify the pairs. this creates a trading opportunity. which means that the process is not mean reverting. If there is a deviation from the historical mean. find two stocks prices of which have historically moved together. Gains are earned when the price relationship is restored. Gains earned when the historical price relationship is restored . Our aim is to identify pairs of stocks with mean-reverting relative prices.STRATEGY
The starting point of this strategy is that stocks that have historically had the same trading patterns (i. the null hypothesis is that = 0. correlation is not key . we are regressing yt on lagged values of yt. In the A Dickey-Fuller test for determining stationarity in the log-ratio yt = logAt −logBt of share prices A and B _yt = μ + yt−1 + "t (17) In other words. which can be exploited. the pairs do not mean-revert good enough to generate satisfactory returns. mean reversion in the ratio of the prices. To find out if two stocks are mean-reverting the test conducted is the Dickey-Fuller test of the log ratio of the pair. constant price ratio) will have so in the future as well. If you have 200 stocks. which makes this quite computer-power and time consuming. . you will have to run 19 900 regressions. If the null hypothesis can be rejected on the 99% confidence level the price ratio is following a weak stationary process and is thereby mean-reverting.e.
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since timing is an important issue. a large number of pairs will be generated.PAIRS TRADING MODEL
Screening Pairs For screening the rules follow the general outline of first "find stocks that move together. The betas are measured on a two-year rolling window on daily data. which makes it difficult for us to stay market neutral. while sectors with low volatility to generate more pairs. How do you identify "stocks that move together?" Need they be in the same industry? Should they only be liquid stocks? How far do they have to diverge before a position is put on? When is a position unwound? Some straightforward choices about each of these questions are made. This implies that we only want to open a position in a pair that is within the same sector. A sector like Commercial services is expected to generate very few pairs. The beta spread must be no larger than 0. but Financials on the other hand should give many trading opportunities. which might not always cover transactions costs even when stock prices converge. We put positions on at a two-standard deviation spread. This gives mean-reverting pairs with a limited beta spread. is that companies within the Financial sector have more homogenous operations and earnings. Therefore a trading rule is introduced regarding the spread of betas within a pair. but to further eliminate the risk we also want to stay sector neutral.2. in order for a trade to be executed. we expect sectors showing high volatility to produce very few pairs. Trading rules The screening process described gives a large set of pairs that are both market and sector neutral. Another factor influencing the number of pairs generated is the homogeneity of the sector. Due to the different volatility within different sectors.
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. By conducting this procedure. The problem is that all of them do not have the same or similar betas. This should not be done randomly." A test requires that both of these steps must be parameterized in some way. which can be used to take positions. “and second “take a long-short position when they diverge. The reason why.
we study the top 5 and 20 pairs with the smallest historical distance measure. as estimated during the pairs formation period. we have an open position when the pair is on its way back again In Short: --Open position when the ratio hits the 2 standard deviation band for two consecutive times.Close position when the ratio hits the mean Trading Period Once we have paired up all liquid stocks in the formation period. gains or losses are calculated at the end of the last trading day of the trading interval. We open a position in a pair when prices diverge by more than two historical standard deviations. Since the positions are effectively self-financing portfolios. This can partly be avoided by the following procedure: We actually want to open a position when the price ratio deviates with more than two standard deviations from the 250 days rolling mean.
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. On the day following the last day of the pairs formation period. If prices do not cross before the end of the trading interval. This last set is valuable because most of the top pairs share certain characteristics. -. However. The position is not opened when the ratio breaks the two-standard-deviations limit for the first time.Basic rule will be to open a position when the ratio of two share prices hits the 2 rolling standard deviation and close it when the ratio returns to the mean. we begin to trade according to a pre-specified rule. we report the payoffs by going one rupee short in the higher-priced stock and one rupee long in the lower-priced stock. Following practice. we base our rules for opening and closing positions on a standard deviation metric. and close the position when the prices have reverted. We unwind the position at the next crossing of the prices. we do not want to open a position in a pair with a spread that is wide and getting wider. We chose rules based on the proposition that we open a long-short position of when the pair prices have diverged by a certain amount. but rather when it crosses it to revert to the mean again.
the payoffs have the interpretation of excess returns. and divides it by the number of pairs in the portfolio. Pairs that open but do not converge will only have cash flows on the last day of the trading interval when all positions are closed out. and a set of cash flows at the end of the trading interval which can either be positive or negative. We consider two measures of excess return on a portfolio of pairs: the return on committed capital and the return on actual employed capital. The excess return on a pair during a trading interval is computed as the sum of the payoffs during the trading interval. Strategy Profits The excess returns for the pairs portfolios that are unrestricted in the sense that the matching
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. it ignores the fact that these cash flows are received early. Therefore. Because any cash flows during the trading interval is positive by construction. A hedge fund would presumably be more flexible in its sources and uses of funds. or we may have none in the case when prices never diverge by more than two standard deviations during the trading interval. The excess return on committed capital takes the sum of the payoffs over all pairs during the trading period.Excess Return Computation Because pairs may open and close at various points during the trading period. Pairs that open and converge during the trading interval will have positive cash flows. We calculate the excess return on employed capital as the sum of the pair payoffs divided by the number of pairs that actually open during the trading period. and understates the computed excess returns. This is a conservative approach to computing the excess return. because it implicitly assumes that all cash is received at the end of the trading period. This measure of excess return is clearly conservative if a pair does not trade for the whole of the trading period. Because the trading gains and losses are computed over long short positions of one rupee. Because pairs can re-open after initial convergence. the payoffs to pairs trading strategies are a set of positive cash flows that are randomly distributed throughout the trading period. we still include a dollar of committed capital in our calculation of excess return. pairs can have multiple positive cash flows during the trading interval. For each pair we can have multiple cash flows during the trading interval. the calculation of the excess return on a portfolio of pairs is a non-trivial issue. In such case computing excess return relative to the actual capital employed may give a more realistic measure of the trading profits.
if there is very little return to be earned. we will use a stop-loss and close the position as we have lost 20% of the initial size of the position. For example. while a portfolio of 5 pairs returns negative profits in 11 trading periods. we will never keep a position for more that 50 days. In particular. On average. a portfolio of 20 pairs has only 6 six-month periods with negative payoffs. The potential return to be earned must always be higher than the return earned on the
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. the strategy buys sells stocks that have done well relative to their match and buys those that have done poorly.stocks do not necessarily belong to the same broad industry categories. The opposite is true at the second crossing (convergence): part of the drop in the winner’s price can reflect a bid quote. Since pairs-trading is in essence a contrarian investment strategy. and part of the rise of the loser’s price an ask quote . If the ratio develops in an unfavourable way. Finally. the mean reversion will occur in approximately 35 days . the dramatic drop in the excess returns suggests that a non-trivial portion of the profits in pair trading may be due to bid-ask bounce. The excess returns are still significantly positive in a statistical sense. None-the-less. There are diversification benefits from combining multiple pairs in a portfolio. As the number of pairs in a portfolio increases. this difference raises questions about the economic significance of our results when we include transactions costs. Risk control Furthermore. as does the range of the realized returns and the frequency of negative portfolio excess return during a period. Part of any observed price divergence is potentially due to price movements between bid and ask quotes: conditional on divergence the winner’s price is more likely to be an ask quote and the loser’s price a bid quote. Since we have used these same prices for the start of trading. our returns may be due to the fact that we are implicitly buying at bid quotes (losers) and selling at ask quotes (winners). there will be some additional rules to prevent us from loosing too much money on one single trade. The distribution of pairs payoffs is skewed right and peaked relative to the normal distribution. and there is no reason to wait for a pair to revert fully. during the full sample period of 34 years. the portfolio standard deviation falls. the returns may be biased upward due to the bid-ask bounce. It is difficult to quantify which portion of the profit reduction is due to bid-ask bounce and which portion stems from true mean reversion in prices due to rapid market adjustment.
is that a minor beta spread is allowed for.
3. In addition. there is a possibility for us to make our own decisions. The main risk we are being exposed to be then the risk of stock specific events that is the
risk of fundamental changes implying that the prices may never mean revert again.
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. 10 equally weighted positions Risks 1. The rules described are totally based on statistics and predetermined numbers. we have to accept this beta spread. but also a short enough time not to loose time value. This should be enough time for the pairs to revert. we can of course avoid investing in such pairs. or at least not within 50 days. In order to find a sufficient number of pairs.2 . Summary: . Stop loss at 20% of position value . In order to control for this risk we use the rules of stop-loss and maximum holding period. which is obtained by simultaneously investing in several pairs. Through this strategy we do almost totally avoid the systematic market risk. Maximum holding period < 50 trading days . but the spread is so small that in practise the market risk we are exposed to is ignorable. The last 50 days we will spend trying to close the trades at the most optimal points of time. 4. Beta spread < 0. Also the industry risk is eliminated. The reason there is still some market risk exposure.benchmark or in the fixed income market. From the rules it can be concluded that we will open our last position no later than 50 days before the trading game ends. If we for example are aware of fundamentals that are not taken into account in the calculations and that indicates that there will be no mean reversion for a specific pairs. The maximum holding period of a position is therefore set to 50 days. Sector neutrality . Initially we plan to open approximately 10 different positions. since we are only investing in pairs belonging to the same industry. This risk is further reduced through diversification. 2.
but that a few short run failures will ruin our overall excess return possibilities.
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.Finally. we do face the risk that the trading game does not last long enough. It might be the case that our strategy is successful in the long run.
book loss if spread is going against desired direction by more than 5% or 20 % of the margin money is at risk b.STEPS IN PAIR TRADING
1.mean and the 3 standard deviations on the either side.. 7. 8. Find the price ratio of the pairs for the desired period (1 year) . if pair is not reverting back and is dull without movement for 35 days. Keep track if trade is not going according to your desired direction…. Hold the position till the immediate target and reverse to book profit.Determine buy/sell for individual pairs and determine quantities according to available lot size such that money value of buy is equal to money value of sell. Suggested correlation is greater than 85%. 3. a. 2. Selecting pairs of highly correlated stocks from the same industry. Close the position if there is any potential announcement in coming days. Observe the one year price ratio of the pair and identify the resistance in terms of the nearest standard deviation.
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. 6. Choose the pairs which are now showing a mean reversion. 4. 5 .
It is in the recent past that they have diverged from each other.00
Prices of the stocks.00 100. the next thing is to find out the Ratio of the
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. Ratio = Stock Price of PNB / Stock Price of BOI
After determining the correlation amongst the stocks.00 100.00 250.00 10/7/2008 11/7/2008 12/7/2008 7/7/2008 1/7/2009 4/7/2008 5/7/2008 6/7/2008 8/7/2008 9/7/2008 2/7/2009 150.00 0.00 200.00 50.CASES OF PAIR TRADING
The pair taken as an example is from the Banking Sector 1.00 600.00 500.00 200.00
700. This is quite evident from the below graph which shows the relative price movement of the two stocks in past one year.90. Also.00 0.
It has been observed that the Correlation between the stocks for the last 1 year is 0.00 350.00 300.00 300. one can notice that the two stocks mostly move in tandem with one another.
PNB BOI 400. Punjab National Bank & Bank of India.
6187 MEAN 1. 1. the sigma levels are determined.9845
Looking at the recent data one can notice the trend in the movement of the Price Ratio of the two stocks. The result for the same are as below: Mean Stdev 1. We find upto plus and minus 3 sigma levels as shown below. D.D.D. 1.
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. The next step is to find the average and the standard deviation of the ratios for the past 1 year.7102 0.D.D.D. 1.4359 MEAN-2 S.7102 MEAN+ S. 1.This Ratio forms the basis of our findings.8016 MEAN+2 S. 1.0914
On the basis of the mean and the Standard deviation (S.5273 MEANS.).D. MEAN3 S. 1.8930 MEAN+3 S.
5017 1.6674 1.25 210.5262 1.55 391.55 241.95 226.6219 1.75 250.35 404.6148 1.90
DATE 2/2/2009 2/3/2009 2/4/2009 2/5/2009 2/6/2009 2/9/2009 2/10/2009 2/11/2009 2/12/2009 2/13/2009 2/16/2009 2/17/2009 2/18/2009 2/19/2009 2/20/2009 2/24/2009 2/25/2009 2/26/2009 2/27/2009 3/2/2009 3/3/2009 3/4/2009 3/5/2009 3/6/2009
Bank of India 239.4832 1.4795 1.65 346.20 251.90 221.6364 1.60 325.4713 1.00 223.05 292.75 408.6276 1.6488 1. (end Feb) before reverting back to mean Recently it has started its journey back to mean and one can sense an opportunity to initiate a long on PNB-BOI Pair.2 standard deviation.30 238.10 364.5681 1.40 324.4856 1.6610 1.Table shows the data for the month of February 2009 and some days of march when the Strategy is initiated.80 197.70 221.55 220.15 220.6085 1.40 196.25 369.80 362.10 397.70 220.00 238.6735 1.55 341.95 396.35 306.45
RATIO 1.35 225.90 406.6076 1.6498 1.80 244.6320 1.55 219.70 250.4968 1.30 374.45 408.05 310.75 400.5826
In the graph below we find out that ratio reverts back to mean (mid Jan)) after nearly touching + 2 Standard Deviation.6616 1.
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.65 254. Punjab National Bank 391.6343 1.65 399.50 402.90 237.25 203.35 249. Since then ratio moved towards the mean and after crossing the mean it has further moved below to cross .20 337.20 312.6533 1.
Total Amt 37308 39290 Total Margin
15319.8000 1.6 7858
Position Long Short
Script PNB BOI
Price when Initiated 6-Mar-09 310.D.6000 1.D. ME AN+3 S . ME AN-S .D.45 (200 shares) No. ME AN+2 S .D.PAIR TRADING
2.2000 1. of lot 120 200 Margin Amt 7461.6
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. ME AN ME AN+ S .D.2000 2.4000 1.D.9 196. LONG SHORT PNB Futures at 310.0000
4/ 7/ 20 08 5/ 7/ 20 08 6/ 7/ 20 08 7/ 7/ 20 08 8/ 7/ 20 08 9/ 7/ 20 08 10 /7/ 20 11 08 /7/ 20 12 08 /7/ 20 08 1/ 7/ 20 09 2/ 7/ 20 09
Ratio ME AN-3 S .
We initiate as on 6th MARCH 2009.0000 Ratio (PNB / BOI) 1. ME AN-2 S .90 (120 shares) BOI Futures at 196.
15319.55 197. Net 6 Profit/Loss 34.20 340.7330 1.85 196.15 328.60 189. Hence we book profit and close both the positions by buying BOI Futures and selling PNB Futures.00 RATIO 1.20 316.7018 1.6 366.35 342.15 199.71).The table below shows the movement of the ratio of the Price of the two stocks DATE 3/9/2009 3/12/2009 3/13/2009 3/16/2009 3/17/2009 3/18/2009 3/19/2009 3/20/2009 3/23/2009 3/24/2009 Punjab National Bank 304.65 332.6668 1.25 192.58259 1 1.85 206.We find that with time ratio starts reverting back and as on 24th March 2009 ratio is 1. Total Margin Price when Initiated of lot Amt Amt closed Profit/Loss 6-Mar-09 24-Mar-09 310.80 194.79.01 %
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.7172 1.90 204. Scrip t PNB BOI Price when No.7985
We will hold our position till ratio reverts back to mean (1.90 Bank of India 180.35 336.25 203.7475 1.60 361.6811 1.7324 1.9 120 37308 7461.6844 1.6834 1.10 342.55 366.45 200 39290 7858 204 -1510
Position Long Short
Total Margin Ratio when initiated Expected Ratio 1. The detailed Summary is as shown below.9 6720 196.
7578 0. This is quite evident from the below graph which shows the relative price movement of the two stocks in past one year. one can notice that the two stocks mostly move in tandem with one another.
It has been observed that the Correlation between the stocks for the last 1 year is 0.1171
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Punjab National Bank & Bank of Baroda. Ratio = Stock Price of PNB / Stock Price of BOB This Ratio forms the basis of our findings.85. The next step is to find the average and the standard deviation of the ratios for the past 1 year.2. The result for the same are as below: Mean Stdev 1.
After determining the correlation amongst the stocks. Also. the next thing is to find out the Ratio of the Prices of the stocks.
D.6562 1.70 247. D.95 396.6372 1.10 364.On the basis of the mean and the Standard deviation (S.80 216.6291 1.40 RATIO 1.25 236.4991 1. 1. We find upto plus and minus 3 sigma levels as shown below.6564 1.5740 1.20 228.5039 1.60 325. DATE 2/2/2009 2/3/2009 2/4/2009 2/5/2009 2/6/2009 2/9/2009 2/10/2009 2/11/2009 2/12/2009 2/13/2009 2/16/2009 2/17/2009 2/18/2009 2/19/2009 2/20/2009 2/24/2009 2/25/2009 2/26/2009 2/27/2009 3/2/2009 3/3/2009 3/4/2009 3/5/2009 3/6/2009 Punjab National Bank 391.15 246.55 249.5954 1.35 231.25 369.30 374.90 212.D.90 Bank of Baroda 246.20 312.65 346.15 195.05 310. the sigma levels are determined.6407 MEAN 1. MEAN -3 S.6158 1.4986 1.45 408.9919 MEAN+ 3 S.55 192.50 402.6059 1.5236 MEANS.6144 1.6390 1. 1. 2.35 404.20 225.6524 1.6295 1.75 244.75 408.5267 1.75 400.35 306.10 217.55 391.5338 1.1089
Looking at the recent data one can notice the trend in the movement of the Price Ratio of the two stocks. Table shows the data for the month of February 2009 and some days of march when the Strategy is initiated.8748 MEAN+2 S.00 247.50 215.70 204.20 337.10 397.85 243.6154 1.D.00 207.70 224.6159
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.05 292.4935 1.D.4066 MEAN-2 S.40 324.05 245.90 406.6176 1. 1.60 244.35 220.D.).65 399.6602 1.5860 1.80 362.7578 MEAN+ S.6154 1.55 341. 1.15 250. 1.D.
Since then ratio moved towards the mean and after crossing the mean it has further moved below to cross . (start March) before reverting back to mean Recently it has started its journey back to mean and one can sense an opportunity to initiate a long on PNB-BOB Pair.
We initiate as on 6th MARCH 2009.90 (100 shares) BOB Futures at 192. LONG SHORT PNB Futures at 310.In the graph below we find out that ratio reverts back to mean (22nd Jan)) after touching + 1 Standard Deviation.4 (150 shares)
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.2 standard deviation.
75).643011 1.2 316.55 203.657314 1.612747 1.9 398.651736 1. The detailed Summary is as shown below.65 RATIO 1.4 150 28860 Total Margin
Margin Amt 6218 5772
The table below shows the movement of the ratio of the Price of the two stocks after the pair is initiated.3 247.Position Long Short
Script PNB BOB
Price when Initiated No.9 223.631192 1.9 227.1 342. Hence we book profit and close both the positions by buying BOB Futures and selling PNB Futures.6 361.65 203.657703 1. Date 3/9/2009 3/12/2009 3/13/2009 3/16/2009 3/17/2009 3/18/2009 3/19/2009 3/20/2009 3/23/2009 3/24/2009 3/25/2009 3/26/2009 3/27/2009 Punjab National Bank 304.650798 1.760943 1.45 235.4 198.772057
We will hold our position till ratio reverts back to mean (1. of lot Total Amt 6-Mar-09 310.35 438.55 191.77.75 206.7 207.35 342.63667 1.2 340.15 328.85 Bank of Baroda 183.35 336.We find that with time ratio starts reverting back and as on 27th March 2009 ratio is 1.65 332.8 208.614783 1.55 366.9 100 31090 192.
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.5 225.1 414.650665 1.765802 1.
of lot Amt Amt closed Profit/Loss 6-Mar-09 27-Mar-09 310.5
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Net 11990 Profit/Loss 37.9 100 31090 6218 438.65 -8287.59%
4507.Position Script Long Short PNB BOB
Price Price when Total Margin when Initiated No.5
Total Margin Current Ratio Expected Ratio 1.6159 1.4 150 28860 5772 247.85 12795 192.
3. The result for the same are as below: Mean Stdev 0. Ratio = Stock Price of PNB / Stock Price of BOB This Ratio forms the basis of our findings.
Shiv-Vani Oil Exploration & Aban Offshore
It has been observed that the Correlation between the stocks for the last 1 year is 0. The next step is to find the average and the standard deviation of the ratios for the past 1 year.92. the next thing is to find out the Ratio of the Prices of the stocks.2256 0.
After determining the correlation amongst the stocks.0657
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. This is quite evident from the below graph which shows the relative price movement of the two stocks in past one year.
00 229.55 381.75 93.2481 0.60 102.00 438.90 287.95
DATE 2/2/2009 2/3/2009 2/4/2009 2/5/2009 2/6/2009 2/9/2009 2/10/2009 2/11/2009 2/12/2009 2/13/2009 2/16/2009 2/17/2009 2/18/2009 2/19/2009 2/20/2009 2/24/2009 2/25/2009 2/26/2009 2/27/2009 3/2/2009 3/3/2009 3/4/2009 3/5/2009 3/6/2009 3/9/2009 3/12/2009 3/13/2009 3/16/2009 3/17/2009
ABAN OFFSHORE 469. 0.65 232.65 430.30 105.3429 0.25 105.2750 0.2256 MEAN+ S.10 348.3570 MEAN+3 S.85 254. 0. 0.00 443.00 103.80 103.55 102.0285 MEAN-2 S.4209 0.On the basis of the mean and the Standard deviation (S.05 101.4227
Looking at the recent data one can notice the trend in the movement of the Price Ratio of the two stocks.2422 0.75 94.D.00 104.2214 0.75 317.4112 0.2542 0. We find upto plus and minus 3 sigma levels as shown below.2876 0.05 103.2996 0. 0.D.80 105.3556 0.45 417.2506 0.3992 0. 0.65
RATIO 0.10 396.3655 0.10 92.40 413.3572 0.70 256.55 106.2913 MEAN+2 S.2471 0. Table shows the data for the month of February 2009 and some days of march when the Strategy is initiated.50 107.45 286.D. D.90 466.35 106.2886 0.80 435.D.70 104.20 111.2442 0.10 104.75 455.50 95. MEAN3 S.30 106.D.95 355.2454 0.3570 0.50 102.2253 0.90 231.70 270.2420 0. 0.3935 0.40 91. the sigma levels are determined.).0942 MEANS.80 360.D.25 293.95 111.00 420.85 103.40 285. SHIV-VANI OIL EXPLORATION 105.3281 0.1599 MEAN 0.2499 0.90 431.2630 0.40 440.10 97.2864 0.05 353.2446 0.3312
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.15 101.50 104.
At this point one can sense an opportunity to initiate a short on Shiv-Vani .
We initiate as on 17th MARCH 2009. of lot Total Amt Margin Amt 17-Mar-09 286. After that it has started its journey back to mean and has crossed the +2 standard deviation mark on 12th March.95 (250 shares) ABAN Futures at 286.Aban Pair.65 100 28665 5733 94.65 (100 shares) Price when Initiated No.5
Position Long Short
Script Aban Shiv-vani
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. SHORT LONG SHIV-VANI Futures at 94.95 250 23737.5 4747.In the graph below we find out that ratio moves towards + 2 standard deviation ( In Feb) and crosses + 2 Standard Deviation (Early March). It further moves on to touch + 3 standard deviation (2nd March).
2937989 0.2691365 0.29942 0.6 332.95 -500
Total Margin Current Ratio Expected Ratio 0.3312 0.2 367.7 96. SHIV-VANI OIL EXPLORATION 97 95.85 13420 94.1 420.95 329.8 96. of lot Amt Amt closed Profit/Loss 17-Mar-09 27-Mar-09 286.65 100 28665 5733 420.5 Profit/Loss 123. Hence we book profit and close both the positions by buying Shiv-Vani Futures and selling Aban offshore Futures.95 250 23737.3108046 0.6 98.5 96.The table below shows the movement of the ratio of the Price of the two stocks after the pair is initiated.
Position Script Long Short Aban Shivvani
Price when Total Margin Price when Initiated No.2255 ROI
Net 10480.2914138 0.3167864 0.2303. The detailed Summary is as shown below.25 329.2256).5 4747.95
DATE 3/18/2009 3/19/2009 3/20/2009 3/23/2009 3/24/2009 3/25/2009 3/26/2009 3/27/2009
ABAN OFFSHORE 306.2 318.95 326.4 104.85
RATIO 0.3173208 0.5 101.28%
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.05 97.We find that with time ratio starts reverting back and as on 27th March 2009 ratio is 0.2303671
We will hold our position till ratio reverts back to mean (0.
These profits are uncorrelated to the sensex.Conclusion
Pair Trading is a market neutral strategy that allows you to take positions which usually result in generating profits irrespective of overall market direction. Pairs trading performed well over difficult times for U. Larger players such as institutions are likely to have a relative advantage in their ability to command leverage to take positions and there ability to execute trades cheaply. pair trading might simply be more profitable in times when the stock market performs poorly. On the other hand.
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. which are close substitutes according to correlation and minimum distance criterion using a metric in price space. however they do exhibit some sensitivity to the spreads between small and large stocks and between value and growth. We form pairs of stocks.S. the profitability of the strategy clearly depends upon the price and the impact of execution. with are robust to conservative estimates of transaction costs. We examine contrarian strategies based on the notion of co integrated prices in a reasonably efficient market. the pairs strategy had some of its best performance. Because the strategies are trading intensive. On the other hand competition in the industry and the price impact of large trades may be important factors limiting the scale of pairs trading.S. stock market suffered a dramatic real decline from 1969 through 1980. We find that trading suitably formed pairs of stocks exhibits profits. known as Pairs Trading. stocks. When the U. Perhaps after its discovery in the early 1980’s by Tartaglia and others. Though it is not risk neutral strategy but when combined with proper risk management mechanism it provides opportunity of generating considerable returns. It is one of the strategies employed by hedge funds seeking greater alpha returns. competition has decreased opportunity.
Pairs Trading .
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.traders-mag.Prof Andrei Simonov.com
Pairs Trading Strategy and Statistical Arbitrage – by Dan Pipitone http://ezinearticles.rightpairs.com
Selection of right Pairs www. Convergence Trading.Quantitative Methods and Analysis By – Ganapathy Vidyamurthy
Simulated Trading An Analysis Of Pair Trading.
Pair trading www.com/mentoring. Cointegration.investopedia.www. Ehrman
Pairs Trading .Bibliography
The Handbook of Pair Trading By – Douglas S. www. By.com.