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Pairs Trading: Your Yummy New Snack

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January 9, 2017
pairs trading primer
Fredrik Broden

Where would we be without the ham-and-cheese sandwich? Or chicken noodle soup? Would peanut butter even exist without jelly? Sure, you can eat any of those things without the other while sitting at your desk trading. But if staring long and hard at an individual stock or index to figure out a strategy is yesterday’s lunch, maybe that stock or index could be paired with another to make a delicious new strategy. So, what’s a “pair”? Think of pairs trading as a bullish position in one stock or index, combined with a bearish position in another. You might consider a pairs trade for the same reason you eat peanut butter with jelly. The constituent parts are fine on their own. But when you combine them, things can get interesting.

Your Ingredients List

For pairs trading to make any sense, you need to understand a few concepts.

Correlation. This is more or less how two stocks move in the same or different directions at the same time. Statistically, correlation is measured from -1.00 (perfect negative correlation, where one stock goes up and the other goes down) to +1.00 (perfect positive correlation, where two stocks always go up and down together). Most of the time, the correlation between two U.S. equities or equity indices is usually positive, from 0.01 to 1.00.

When you look at two stocks or indices to comprise a pair, a positive 0.60 or higher correlation is a good place to start. Higher than that is good. Lower than that, and the relationship between the two stocks can become weak. And when the long stock in the pair goes down and the short stock in the pair either goes up or doesn’t drop, it can lead to unappetizing surprises.

To find correlation values, go to the Charts page on the thinkorswim® platform by TD Ameritrade. Then: 

1. Type in “SPX–NDX” in the symbol field as an example of a pairs chart.

2. Click on the Studies button, then Add Study, then All Studies, then click on “O–P” in the list of studies and select PairCorrelation. It’ll load up the correlation between the two symbols that you entered, in this case the SPX and NDX.

3. Enter any two symbols in the same way “ABCD–XYZ” and you can see the correlation between them. (See Figure 1.)

pair correlation

FIGURE 1: HOW CORRELATED IS A PAIR?

How well do these two get along? The Pair Correlation study at the bottom of the price chart shows if the pair is going strong, or not. Source: thinkorswim by TD Ameritrade. For illustrative purposes only. Past performance is no guarantee of future results.

Selection. This is figuring out when you use stock or options, or both. A long stock/short stock pairs trade can use up a lot of trading capital and have a large amount of risk if the pair moves against you. Options, particularly option spreads like verticals, can have lower capital requirements and defined risk. A lower capital requirement means that if you want to trade pairs, you can allocate a relatively small amount of capital to a bullish vertical in one symbol, and a bearish vertical in another. With defined risk, even if the pair’s correlation collapses, your bullish stock crashes, and your bearish stock rallies, the verticals have a defined max potential loss. The loss still hurts. But it doesn’t have to be fatal.

The main downside to options is commissions. Two verticals for a pairs trade has a commission on four legs. Also, the max potential profit on verticals in a pairs trade is limited, making the commissions a larger factor in doing the trade.

Notional Value. Think about a pairs trade that buys 100 shares of stock A for $100 and shorts 100 shares of stock B at $50. They’re highly correlated, they move up and down together most of the time, and you think stock A will outperform stock B by rising more or dropping less.

If both stocks drop, but stock A drops 5% to $95, and stock B drops 6% to $47, stock A has indeed performed better than stock B. It’s dropped less. But how’s your P/L? Long 100 shares of stock A have lost $500. Short 100 shares of stock B have made $300. You were right on your assessment of the pairs trade, but it lost money. Why?

The notional value of the long shares of stock A was 100 x $100 = $10,000. The notional value of the short shares of stock B was 100 x $50 = $5,000. Stock A had 2x the notional value of stock B, so the pairs trade was weighted heavily toward stock A.

If the notional values were equalized by shorting 200 shares of stock B, the pairs trade would be profitable if stock A dropped $5 and stock B dropped $3. One hundred shares of stock A would lose $500, but short 200 shares of stock B would make $600. The difference in notional values might not be a big deal in two stocks that have roughly the same price. But it becomes a bigger deal if you pairs trade with futures or index products.

A Splash Of Sectors

The first pairs trade to consider is an intrasector trade between two stocks in a particular industry like technology, health care, or energy, where correlation is often high. Consider two hypothetical large oil companies, GTPO and MNAL. Say you chart the “price” of the pair GTPO–MNAL.

If the pair price on the chart has been moving up, it means GTPO has been outperforming, either rising more or dropping less than MNAL. If the pair price has been moving lower, the opposite is true. If you believe that the pair price will continue to go higher, and GTPO will continue to outperform MNAL, you could buy shares of GTPO and sell shares of MNAL. If you believe the pair price will go lower, you could sell GTPO and buy MNAL.

Why don’t you just buy MNAL, if you think the pair price will go lower? Or buy GTPO if you think the pair price will go higher? In fact, the price of the pair could go up even when prices of both stocks are going lower. Picking one of the stocks isn’t a pairs trade. You’re just making a directional bet on that stock.

Now, you’re making a directional bet on the pair, but the pair may have a couple of advantages. First, you may think a pair is mean reverting. That is, the pair price might oscillate above and below some average level on a regular basis. Let’s say you think the average pair price of the two stocks is $12. If the current pair price is $15, and you think it might revert to $12, you could short GTPO and buy MNAL. If the current pair price is $9, you might buy GTPO and short MNAL. You might be able to evaluate the chart of the pair price more easily than one of the component stocks. Second, the pair may have less risk than either of the component stocks. If the stocks are highly correlated, and in the same industry, the long and short shares in the pairs trade offset each other to a certain degree. They act as a hedge for one another.

A Pinch Of Indices

Another type of pairs trade is interindex, like SPX versus NDX. Think big cap versus small cap. Correlations between the major U.S. equity indices tend to be pretty high, which make them interesting pairs candidates. You can approach them like a stock versus stock pair trade. Yet keep in mind that SPX and NDX don’t have underlying shares, so you’d need to trade that pair using options.

With options, think about positive (bullish) deltas in one symbol, and negative (bearish) deltas in the other. You’ll also need to think about volatility (vol). SPX typically has a lower implied volatility than NDX because SPX’s large-cap stocks are somewhat less volatile than NDX’s small-cap stocks. But if the implied vol was the same for both, it might suggest SPX’s implied vol was high relative to NDX.

If you looked at a chart of SPX versus NDX and thought that the pair price might go higher, you could consider putting on bullish deltas in SPX and bearish deltas in NDX. Given the relatively high implied vol in SPX, you might sell a put vertical, for example, in SPX to generate positive deltas because the higher implied vol would mean credit spreads have higher prices. And you might buy a put vertical in NDX to generate negative deltas, because lower implied vol would mean debit spreads have lower prices.

A Dash Of Markets

A third avenue is an intermarket pairs trade, like S&P 500 versus Treasury bonds. Get your big kid pants on for this. Recently, threats of higher rates have pushed both Treasuries and U.S. stocks lower, at least in the short term. Maybe you think that Treasuries have sold off a bit much, and the S&P 500 hasn’t caught up to the downside. You may consider a pairs trade that’s long deltas in Treasury futures (/ZB) and short deltas in S&P 500 futures (/ES). Notional value here is critical.

At $1,000 per point, /ZB at $170 has a notional value of $170,000. At $50 per point, /ES at $2,200 has a notional value of $110,000. /ZB is about 50% larger. To get the risk between the /ZB and /ES positions more equal, you might consider two positive deltas in /ZB for every three negative deltas in /ES. With implied vol in /ZB at 11%, and in /ES at 13%, you may want to consider sticking with the 2:3 ratio. But if they were different, say /ZB at 11% and /ES at 17%, that would make /ES vol 50% larger than /ZB vol. If you factor that in, the 2:3 ratio would now be one /ZB to one /ES because the 50% smaller notional value of /ES is offset by the 50% larger volatility.

Intermarket pairs trades have the most moving parts, and require the most confidence, experience, and account size. Even if you’re not quite ready for those, the concepts discussed here can be applied to any pairs trade.

Watch Celebrity Chefs At the Closing Bell

This article just scratched the surface of pairs trading, a part of the market that’s often both demanding and rewarding. Pairs trades can be complex, have high commissions, and carry a lot of risk. But they also make you push the boundaries of your trading knowledge. And that’s a good idea for all of us. Because really, who wants just jelly?

To read more about pairs trading, see the article "Opposites Attract" from thinkMoney15, Spring 2012.

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