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Power Couple: Getting Cozy with Pairs Trading

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December 8, 2015
Pairs trading goes together like ...

Ever find yourself in the middle of a “typical” market situation that suddenly feels not so typical? If that’s the case, you may want to explore one of the more sophisticated market strategies: pairs trading.

Pairs trading involves the simultaneous trade of two correlated securities. Highly correlated securities tend to move in the same direction, although the percentage change of each underlying’s move can vary. When the correlation between the two underlying securities gets out of whack, especially to an extreme level, this could be the genesis of a pairs trade, which aims to exploit that (presumably temporary) gap.

Now, the pair could be positively correlated, meaning both are expected to move in the same direction: the S&P 500 (SPX) and the Dow Jones Industrial Average ($DJI), for instance. Or, they might be negatively correlated—when one goes up, the other tends to go down. Think SPX and the CBOE Volatility Index (VIX). Either positive or negative correlation could produce a potential pairs trade.  

Here’s a strong correlation example: The S&P 500 and Dow Jones have moved in the same direction 95% of the time over the last 50 years, according to exchange data. But here’s a cozy couple that might not seem as obvious: corn and crude oil futures. Correlated? Yes. Over 40% of harvested corn is pegged for ethanol production, landing it in the “energy” category right next to crude.

How about corn futures and soybean meal futures? Yep. They compete as substitutes to nourish feeder cattle. Gold versus silver, oil versus natural gas, bonds versus stocks … yes, yes, and yes. Relationships and correlations exist throughout the financial markets.

Can stocks be used for a pairs trade? Yes, as long as the two underlying listings are correlated and can be shown to have some type of relationship. For instance, Visa (V) and MasterCard (MA) may be correlated. They both receive over 90% of their income from fees and assessments. What about Coca-Cola (KO) and PepsiCo (PEP)? Careful there—while Coke gets over 90% of its revenue from beverage sales, PepsiCo gets the majority of its revenue from its Frito-Lay division and could be considered just as much a food company as a drinks producer.

For help researching candidate pairs trades, log in to the thinkorswim® platform, go to the Fundamentals page, then hit the Analyze tab. There you can find a breakdown of the fundamentals that can drive a stock, including valuation highlights from Trefis®.

How Does a Pairs Trade Work?

Suppose tech stocks are booming and the tech-studded NASDAQ Composite outperforms the S&P 500 over a six-month period. We could hypothesize that eventually the tech sector would come back down to earth and the NASDAQ would resume its normal, in-line correlation with the S&P. A pairs trader might opt to buy (go long) the undervalued S&P 500 (via the E-Mini S&P 500 Future) and sell (short) the overvalued NASDAQ Composite (via the E-Mini Nasdaq 100 Future). The assumption is that the correlation will come back in line, producing a profitable trade.

Size Matters

Always consider the risks. What if the tech sector continues to outperform the broader market? Or, what if the pair’s divergence from their normal correlation lasts longer than expected? Either scenario could result in a losing trade.

Once you identify a correlation, the next question is whether you want to put on a 1:1 trade or use a different ratio. First, determine the notional value of each underlying security—that is, the face value. This will help you trade correlated securities at the most equal dollar value, ensuring a true pairs trade.

For example, let’s imagine you think oil prices are going to decline and that natural gas prices will rise. You might establish a pairs trade by selling light sweet crude oil futures (/CL) and buying natural gas futures (/NG). To calculate the notional value of these contracts, multiply the value of a one-point move in the underlying by the current price. The following numbers are for illustrative purposes only and do not reflect current market pricing:

/CL notional value = $48.12 x 1,000 = $48,120

/NG notional value = $2.252 x 10,000 = $22,520

By calculating the notional value of each contract, you immediately see that the crude oil future is about twice the size of a natural gas contract. In order to properly execute a pairs trade, you should consider buying two /NG contracts for every /CL contract sold.

Very Important: Keep the Duration Short

Pairs trading is usually meant to be a short- to medium-term holding at best. Even the most highly correlated names tend to lose correlation over longer durations. As always, risk should be monitored closely and tied directly to the size of your account and your risk tolerance.

The idea behind a pairs trade is simply to take advantage of divergences in highly correlated securities. To increase your odds of success, track relationships over time, identify price divergences, and hypothesize when they may come back in line. 

NC
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