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The edge of pair trading, profitability of the strategy

Introduction

We explained in our previous article that today, stock pairs constitute an integral part of the trading strategy of all professional traders, banks, and investment funds. That strategies use different ways to identify trading opportunities by monitoring the difference in the prices of two stock titles. We have also shown that we do not need to know the direction in which the market will go in order to achieve a profit. We already know that stock pairs are a market-neutral strategy and that we have a myriad of stock titles for trading. Stock pair trading can be easily automated using specialised software.

The edge of stock pairs

Long-term profitability is based on three pillars: 1) limited risk of loss, 2) speculation on the return of the ratio of prices to its long-time average, without the influence of external factors, 3) broad portfolio diversification thanks to the ample trading opportunities.
1st Survival Law: Minimize risk!

Risk management – mitigating the risk of loss

As we have already explained in a previous article in our series, the foundation of a trader’s sustained success on stock markets is risk management = limiting the maximum potential loss to an acceptable level. Whereas a simple Long / Short position may sustain a theoretically unlimited fatal loss, a pair position is protected from this risk, by its very nature. Thanks to the simultaneous opening of an identical (in terms of dollar value) Long and Short position, the risk of loss due to a sudden sway in the market is fully eliminated. If, for example, the entire market dropped due to adverse fundamental news, the profit from the short position would cover the loss from the long position. The total profit will therefore remain close to zero in spite of the whole market having sustained a significant loss. Thanks to that, a trader may continue to trade and accumulate a profit. Remember: Risk management is the most important part of every investment strategy.

Speculating on a return of the price ratio to its long-term average

Most traders agree that it is difficult (or even impossible) to predict the price of a single stock title. But there is evidence that the it is possible to predict the behaviour of a group of shares (in our case a stock pair). How is that possible?
It is difficult (or even impossible) to predict the price of a single stock title
The price of a share is influenced by external and internal factors. External factors are those that a company itself cannot influence in any way: overall market sentiments, taxes, legislation, natural catastrophes, etc. Internal factors, on the other hand, are fully under a company’s control, telling us about its position and success on the market: innovations, market share, revenue, profit, dividend payments, etc.
If we trade in two stock titles in a pair opposite one another, i.e., one Long and the other Short, the external factors will cancel each other out. It does not matter to us whether the entire market moves upwards, downwards, or to the side! The pair position balances out, or eliminates these “global” shifts. Solely by trading stock in a pair, we have managed to eliminate a large portion of the variables that have an impact on the outcome of our transaction! Speculating on the relative movement of the prices of two stock titles against each other is therefore significantly easier than speculating on the absolute movement of prices themselves.
The ratio of the prices of two randomly selected (correlating) stock titles (net of the impact of external factors) behaves as a stationary process. That means that it is stable in time, oscillating around the long-term average. Using statistical methods, we can study that behaviour, describe it, and quantify it. If the ratio of prices sways outside of the usual range (usually 2nd standard deviation), we can speculate with a high level of success (around 65%) on a return to normal, thereby collecting a profit.

Portfolio diversification

No trading strategy generates solely profits. Loss is an integral part of stock trading and stock pairs are no exception. A loss occurs when the difference between prices does not revert to normal within the set time. Rules for leaving a position must be set to deal with this adverse development. The simplest and at the same time very effective method is a time stop-loss – the closing of a position no later than at the end of a day defined in advance.
2nd Survival Law: Diversify Your Portfolio!
On the basis of an analysis of an extensive set of data, it is possible to state that stock pairs manifest a stable profitability of 60 – 65%. That means that 60 – 65% of pair transactions are profitable, 35 – 40% of transactions are loss-making (transaction results already factor in the commission paid for the opening and closing of a position, i.e., the profit / loss is net). The average profit roughly corresponds to the average loss (RRR = 0.65 – 1.2).
Given the above and given the number of trading opportunities (see the last previous article in the series), a trading portfolio can be put together that will have more than a 95% or 99% likelihood of yearly profit. How? We will show you in the next part of our series.