What is Pair Trading?

If you have travelled on a highway, you must have noticed that on the highway on which your vehicle runs at a high speed, there is a small or narrow road running alongside it, which is called a service road. Vehicles travelling short distances travel on this road which have to go to nearby shops, houses or other nearby places. Both these roads run parallel to each other.

Now imagine that the work of building a new highway and service road begins. The contractor who is building this road finds a tree some distance away on the way to the service road. The contractor building the road decides that he will not cut this tree. And he will build the road by turning it a little near that tree, due to which the road will be different for some distance, but then this service road will start running parallel to the highway again.

The road is built and people start using it.

Now see, both the roads run parallel to each other. Throughout the way, wherever the highway goes up, the service road also goes up, whenever the highway goes down, the service road also goes down, whenever the highway crosses a river, the service road also crosses it. So overall both the roads run exactly the same way and behave exactly the same. There is only one place where the tree comes and obstructs the way on the service road.

Now if we divide all these into different pieces then –

Entities – Highway and Service Road

Relationship – The relationship of both the elements is that they run parallel to each other. As happens with one element (highway), the same happens with the other element (service road)

Relationship Anomaly – Both have parallel running relationship but at one place, where that tree comes, this situation changes

Effect of the anomaly – This anomaly is very small and both roads reestablish their relationship

This example may seem very strange, but if you understand this whole situation of road, service road and tree and their relationship properly, then it will be easy for you to understand the concept of pair trading.

Let us try this

So first of all, let us take two roads or two elements like here we have taken highway and service road, consider them as two companies which are similar, for example, let us take HDFC Bank and ICICI Bank.

Usually, every book on pair trading takes the example of Pepsi and Coca-Cola but both are not listed in India so I am taking the example of HDFC Bank and ICICI Bank, let’s move ahead –

• Both the banks are quite similar to each other
• Both are private sector banks
• Both offer similar banking products and services
• Both have almost similar customer base
• Both have similar presence across the country
• Both banks are governed by similar rules and regulations
• Both banks face similar challenges

If there are so many similarities between these two banks then any change in the business environment that will affect one bank will also affect the other bank. For example if RBI increases the interest rates then both banks will be affected equally and if RBI reduces the interest rates then also the impact will be similar.

So we can say that –

• Elements – HDFC and ICICI Bank
• Relationship – Similar Business
• Based on the information given above, we can conclude –
• Both businesses are of the same type, so the price of their stock and the changes in it should also be similar
• If the price of HDFC Bank stock goes up on some day, then the price of ICICI Bank stock should also go up
• If the price of HDFC stock goes down, then the price of ICICI stock should also go down
• Based on this, a general rule can also be made for all companies –

If there is a good relationship between any two companies, then any change in the price of the first company should also be seen in the price of the second company. And if this is not happening, then there is an opportunity for a trade.

For example, if ICICI stock goes up by X% on some day, then according to this relationship, HDFC stock should also go up by Y% on that day. But if for some reason HDFC’s stock does not move up and remains at its place, then we can say that the price of ICICI’s stock has gone up more than expected compared to HDFC.

In the world of arbitrage, this is seen as an opportunity to buy a cheap stock i.e. HDFC or sell an expensive stock i.e. ICICI Bank.

In short, this can be called the basis of pair trading.

Now you may ask what is the significance of the tree mentioned in the road example here? Remember that this tree had created an anomaly in relation to the two parallel roads.

In the same way, an event in the prices of two stocks connected to each other through a relationship can create an anomaly due to which the price of one stock starts moving differently from the price of the other stock.

This anomaly gives us an opportunity to trade. This anomaly can come due to any reason –

HDFC Bank announces its quarterly results. At that time its effect will be more on the stock price of HDFC and less on ICICI. Due to which there will be a discrepancy in the prices of these two stocks which will be corrected later.

Similarly, when ICICI Bank announces its results, an anomaly may arise.
A senior officer of one of these banks resigns, due to which the price of that stock gets affected while the other stock is not affected.

A lot of rumors spread about one of these stocks, while nothing like this happens in the other stock.
Usually, the price discrepancy is a small event that has an impact at that time. I call it a small event because it affects only one of the two companies.

The relationship between the two stocks in a way sets the basis or rule to which the prices of both the stocks are linked. That is why the things that are mostly useful in case of pair trading are –

• Identifying the relationship between the two stocks
• Measuring the relationship between the two stocks
• Tracking the relationship between the two stocks on a daily basis
• Identifying any anomalies in the relationship between the two

There can be many ways to define the relationship between two stocks but the two most popular techniques are –

• Price spreads and ratios
• Linear Regression
• Both these techniques are different and we will discuss them in detail.
• Before we end this chapter, let me tell you the history of pair trading.

Pair trading was first done by Morgan Stanley in the early 80s. The name of the trader who did this trade was Gerry Bamberger. It is believed that Gerry had discovered this technique a long time ago but he kept it hidden for his own use for a long time. Then one day another trader named Nunzio Tartaglia brought it to the people and made it popular.

At that time many people followed Nunzio Tartaglia because he was considered an expert in quant trading on Wall Street. He was the head of Morgan Stanley’s prop trading desk in the 1980s.

The famous hedge fund DE Shaw used this strategy in the early days.

Some thoughts

As you must have understood, in pair trading you have to sell and buy two stocks or indices simultaneously. Because of this many people believe that this is a market neutral strategy. It is called market neutral because you are both long and short at the same time. But it is not right to believe so because you are long and short on two different stocks.

To be market neutral, you should be both long and short on the same underlying at the same time. Calendar spreads are a good example of this. In calendar spreads, you go long and short on the same underlying on two different dates.

So don’t assume that pair trading is market neutral. It is a trading strategy that tries to take advantage of the difference in the prices of the two stocks. When you buy and sell two stocks simultaneously, you are trying to take advantage of their relative value. That is why I also call pair trading as Relative Value Trading.

In fact, this is a pure arbitrage opportunity. We are buying the stock with a lower price and selling the stock with a higher price. That is why some people also call it Statistical Arbitrage.

Here, low price and high price mean the price in comparison to each other. We will learn how to measure this in the next chapter.

Highlights from this chapter

• The stock prices of two companies engaged in the same type of business tend to move in a similar fashion
• An event in one company may create a discrepancy in the relationship between the stock prices of the two companies for some time
• When this discrepancy occurs, it is an opportunity to trade
• In pair trading, you buy the lower priced stock and sell the higher priced stock
• Pair trading is also known as relative value trading or statistical arbitrage trading