PairTrade Finder® Mini Educational Series: Learn to Pair Trade, Lesson Three

Today, we are sending you the third and final lesson in our 3-part PairTrade Finder® Mini Educational Series.

Remember, in backtesting, the average profit per trade for our Top 30 US Equities Pairs is over $600 and win rates are in excess of 75%. Just one successful trade can cover your entire annual subscription fee.  Join our Free Webinar to learn more.

Happy Trading!
The PairTrade Finder® Team

Pair Trading Educational Series: Lesson 3

“Quants” is the name Wall Street uses for market researchers who use quantitative analysis to develop profitable trading strategies. In short, a quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to divine profitable trading opportunities.

During the 1980s, a group of quants working for Morgan Stanley struck gold with a strategy called the pairs trade.

Institutional investors and proprietary trading desks at major investment banks have been using the technique ever since, and many have made a tidy profit with the strategy.

“It is rarely in the best interest of investment bankers and mutual fund managers to share profitable trading strategies with the public, so the pairs trade remained a secret of the pros (and a few deft individuals) until the advent of the Internet.” (Investopedia)

Online trading opened the lid on real-time financial information and gave the novice access to all types of investment strategies. It didn’t take long for the pairs trade to attract individual investors and small-time traders looking to hedge their risk exposure to the movements of the broader market.

Market Neutrality

Pairs trading has the potential to achieve profits through simple and relatively low-risk positions. The pairs trade is market-neutral, meaning the direction of the overall market does not affect its win or loss. It has been proven that long/short hedge funds have delivered superior performance to their peers using other trading strategies.

Pair trading is not dependent on market direction to make profits. The goal is to match two trading vehicles that are highly correlated, trading one long and the other short when the pair’s price ratio diverges “x” number of standard deviations – “x” is optimized using historical data. If the pair reverts to its mean trend, a profit is made on one or both of the positions.

Empirical Research on Profitability

In June of 1998, Yale School of Management released a paper written by Even G. Gatev, William Goetzmann, and K. Geert Rouwenhorst who attempted to prove that pairs trading is profitable. Using data from 1967 to 1997, the trio found that over a six-month trading period, the pairs trade averaged a 12% return unleveraged. To distinguish profitable results from plain luck, their test included conservative estimates of transaction costs and randomly selected pairs. You can find their study, along with many other pair trading resources, on our blog here.

The broad market is full of ups and downs that force out weak players and confound even the smartest prognosticators.

Fortunately, using market-neutral strategies like the pairs trade, investors and traders can find profits in all market conditions.

The beauty of the pairs trade is its simplicity. The long/short relationship of two correlated securities acts as a ballast for a portfolio caught in the choppy waters of the overall market.

With today’s easy access to real time financial market data and vast amount of inexpensive computing power, quantitative trading strategies – especially those that can be implemented using machines with little human intervention – have become increasingly popular.

Many of these strategies, falling in the “statistical arbitrage” category, continue to earn rather large risk-adjusted returns on paper even after they have been well publicized through articles, and pose serious challenges to the “efficient market hypothesis.”

Recently, Gatev, Goetzmann and Rouwenhorst (2006, hereafter GGR) showed that a pairs trading strategy generates a monthly Sharpe ratio four to six times that of market returns between 1962 and 2002.

In September of 2012, in an Empirical Investigation of an Equity Pairs Trading Strategy, Huafeng Chen, Shaojun Chen and Feng Li showed that “an equity pairs trading strategy generates large and significant abnormal returns…alphas of up to…36% [annually] for an equal-weighted portfolio.”

Then, in 2015, Nicolas Huck and Komivi Afawubo showed that “Returns [for cointegration-based pair trading strategies] are especially high with monthly excess returns, including transaction costs, greater that 1.38% and going up to about 5% over a period of more than 10 years.”

Why Does it Work?

Despite the large abnormal (risk-adjusted) returns associated with pairs trading, we know little about what makes pairs trading profitable. Researchers have found that the type of news released around the divergence date plays a critical role in explaining cross-sectional variations in the profits across different pairs trading positions.

Recent literature, typified by Kovajecz and Odders-White (2004) interprets the apparently high return to such strategies as being a reward for engaging in market-making activities, i.e., trading activities that provide immediacy and price discovery in the underlying securities.

Can you spot the opportunities?

Many online traders spend a lot of their time looking for a method to trade, are constantly changing their methods, or play around with messy spreadsheets.

Using a trading system reduces the emotional side of trading, you are told exactly when to buy and sell and can spend your time focusing on good execution and risk management.

Here at www.pairtradefinder.com we have spent a great amount of time developing a successful trading strategy. ​​​​​​​We are experienced traders and computer programmers that work full-time on delivering products and services to online traders.

Think of us as your partner in your long-term wealth creation strategy. We are not a fly-by-night company.  We have been around for a long time and we will continue to provide the best service to our clients well into the future.

You can receive entry and exit signals for pair trading opportunities directly from your PairTrade Finder® PRO subscription and you can have these signals delivered through just about any mode of communication of which you can think.  Whether you are at work, on the golf course, or on vacation you can receive and act on PRO’s signals.

We look forward to a long lasting and mutually valuable relationship with you.

Thank you for reading and Happy Trading!

To watch a Video Demo of how to use PairTrade Finder® PRO find profitable equities pairs to trade in under 10 minutes, please click here.

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