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Pairs Trading: Who Cares About Trend, Right?

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March 1, 2013

Did you ever look at a runaway stock or index and say to yourself, “that can't go on forever?” You may not have been a perma-bear, but you may have felt that order would eventually need to be restored. If so, then listen up. Futures pairs trading may be a strategy to consider.

Pairs trading is market neutral--meaning you don't care where the stock or index is going, you're just trying to profit from the relationship between highly correlated securities, (i.e. they move together in tandem.) The idea is when two stocks that are highly correlated, and one suddenly starts diverting from that “normal,” you sell the higher-priced security, and buy the lower-priced security, and profit as they revert to historical norms. 

The Trade

First: find a pair to trade. A common product to use is index futures because of their close correlation, leverage, and the liquidity of these markets.

Second: identify when correlations break down, which you can do from the Pairs Trader feature on thinkorswim®, (Figure 1, below). The tool is prebuilt with a 10-period correlation study and a chart of the spread—the difference—between the two securities entered.

Returning to the mean

FIGURE 1: BACK TO THE MEAN.

When one security outperforms another highly correlated security, placing a pairs trade is a bet that things will return to "normal" again soon. Pictured: Pairs Trader in thinkorswim. For illustrative purposes only.

Third: figure out how many contracts of each security to trade. Failing to size the position appropriately will result in different outcomes if one security moves in a particular direction. One method that addresses this issue is to trade similar dollar values or to achieve “dollar neutrality.” For example, if /ES is trading at $1,460 and has a contract value of $50, the dollar value of the trade would be 1,460 times 50—or $73,000. In order to be dollar neutral, you would need to trade enough /NQ contracts that it comes close to equaling $73,000.

The Trigger

During bullish times, small caps and tech tend to take a leadership role in the markets. However, in the spring of 2012 small caps (/TF) were struggling and tech (/NQ) was soaring due to the extreme weight of Apple Inc.'s market cap. Notice in Figure 1, that in early April, the high correlation of these two indices turned negative. The chart of the spread (or /NQ minus /TF) showed that /NQ was solidly outperforming. This kind of market distortion presents opportunity for those betting on a restora tion of market order. The way to capitalize on the anticipated reversion would be to short /NQ and buy /TF. Of course, your risk in this trade is that the correlation continues to break down.

How Many?

So, how many contracts do you trade? On April 6, 2012, /NQ closed at $2,725 and /TF closed at $799. The dollar value of one /NQ contract is $20 times the price of $2,725, or $54,500. The dollar value of one /TF contract is $100 times the price of $799, or $79,900. In order to figure out the ratio, you'll divide the contract value of /TF by the contact value of /NQ, or $79,900/$54,500. The ratio of /NQ contracts to /TF is 1.47. For this trade, you would short three /NQ contracts and buy two /TF contracts. The exit for this type of trade could be when the correlation nears historic norms.

Futures-pairs trading provides you with the opportunity to trade based on the relationship between two securities, not trend. While it's always possible for a correlation to break down longer than capital would permit, you may find pairs trading to be a refreshing approach to trading the markets—particularly when you can't tell where the market is going.

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