t should be fairly clear by this point that technical analysis plays a very

central role in pairs trading. Although it is certainly possible to create

fundamentally driven pairs trades, the methodology suggested throughout this text uses technicals to perform the majority of analyses required
before trading; fundamentals are used simply as an overlay to ensure that
there are no glaringly obvious reasons not captured in the technical indicators to wave managers off trades. Other books are available on the subject of technical analysis for those readers who wish to delve more deeply
into the subject. While some necessary information about technical indicators is included here, this is not intended to be another book on the subject. The goal in this section is to explain technicals as they relate to pairs
trading and to specific methodologies.
While a fundamental analyst considers a huge amount of very subjective data, the technical analyst deals with only three pieces of data: price,
trading volume, and sentiment. He evaluates them to form an opinion on
the likely direction of prices over a shorter period of time. The complete
analyst looks at the fundamentals to decide whether a significant movement is likely or to compare two or more companies on a longer-term
scale; he employs technical analysis to determine the most propitious
time to enter the market. From a pairs trading standpoint, technical analysis plays a much more important role and, in the majority of cases, is the
driving force behind most trades.
Technical analysts use computers to reconstruct past market activity
and test trading theories. The underlying assumption is that a trading system that worked well in the past will work well in the future. System
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THE TECHNICAL ANALYSIS ELEMENT
traders analyze their technical findings in the form of trading methods that
have worked well in the past (over recent months and years) and try to
determine a set of rules in order to project future trading results. This
process, which is called optimizing, seeks the optimum balance between
the values that produce the greatest profit and the values that produce the
smallest loss.
The problem is, of course, that today s price behavior may not resemble yesterday s price behavior at all. Factors that affect prices are almost
countless and in constant flux. This is one of the most significant risks facing a pairs trader and is called model risk. If there is a major flaw in the
trading model, the entire system is likely to go awry and not produce a
profit. The pairs trading approach, however, offers a great advantage over
other methods because it allows a trader to incorporate different indicators and techniques (correlation, technical tools, fundamentals, and risk
management, for example) to achieve a high probability of success without sacrificing statistical relevance. Opportunities are countless.
In this chapter, the major technical indicators most relevant to
pairs trading are defined and discussed. While there are literally thousands of indicators in use worldwide, ranging from public indicators,
available to everyone, to proprietary ones, this exploration will be limited to those that help form a solid foundation for a unified pairs trading
theory. At the end of this section, the reader should have a solid, basic
understanding of those elements of technical analysis needed to become a successful pairs trader.
The indicators discussed in this chapter are broken into three groups:
market strength indicators, moving average indicators, and volume as an
indicator. Market strength indicators compare the number of buyers apparent in the market with the number of sellers apparent in the market.
When this relationship becomes distorted, the market for a given stock is
said to be either overbought or oversold. Moving average indicators, as
the name suggests, center on a stock s moving average for the period of
the indicator. These numbers can be helpful because they give a smoothed
picture of the stock s price action over a given period of time. Volume as

an indicator is used primarily to confirm a trader s view of other information; it is used to gauge the intensity of the underlying market move.
MARKET STRENGTH INDICATORS
Before examining the specific indicators in this group, it will be helpful
to give formal definitions of the terms that these indicators are trying to
measure.101
Technical Tools and Indicators
Overbought: When the market, or an individual stock, is said to
be in an overbought condition, it means that the recent number of
buyers has been disproportionately high compared to the number
of sellers. Regular market forces tend to keep the number of buyers and sellers in equilibrium. Therefore, when an overbought condition exists, one expects downward pressure on the stock as the
number of sellers catches up with the number of buyers until equilibrium is restored.
Oversold: This condition is the exact opposite of an overbought
condition: The recent number of sellers has been disproportionately high compared to the number of buyers. In an oversold condition, upward pressure is exerted on the stock as the number of
buyers catches up with the number of sellers again, as equilibrium is restored.
Relative Strength Index
The relative strength index (RSI) is an interesting indicator because it
does not measure relative strength in the classic sense. Usually, when a
trader refers to the relative strength of a position, he is referring to the
strength of that position relative to the strength of an index or benchmark.
In the case of RSI, the indicator is measuring the relative internal strength
of the position relative to itself. While this seems counteri