No No. We are not talking about some couple making money. Here we will discuss about making bucks through “pair-trading” strategies. This strategy is adopted by those keen on generating absolute returns through the equity market but are wary of market risk – Hedge Funds, Institutional players, FIIs, HNIs and some individuals (maybe you can count me also, once I learnt much about it).
Honestly speaking, I do not believe in such strategies which have no fundamental reasoning behind them. What they have is just a belief that future prices of stocks have relationship with their past prices or other stocks. Being a true Grahameeze and Buffetian, I should not even look at such theories. In his historic book “The Intelligent Investor”, Graham says “The one principle that applies to nearly all these so-called “technical approaches” is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success on Wall Street. In our own stock-market experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by thus “following the market.” We do not hesitate to declare that this approach is as fallacious as it is popular.”
But being a rational investor, who is open to new ideas, I am exploring whether such strategy can provide me a good return (above 10% in a matter of months) on my risk capital. In the same book mentioned above, Graham explains what an investor can do with the risk capital “Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion— the smaller the better—of your capital in a separate fund for this purpose.”
In most simple terms, pair trading is –
- identifying a pair (of two stocks; or an index and a stock; or similar combination), which has in past shown some relationship in their price movements;
- assessing any mispricing if market has made to any or both of them, in relation to the above;
- finally, making trades based on such anomaly
I think example should help us get more clarity.
Let us take IDEA & RCOM as out two stocks whose part price ratios we will study and use for trading. Past closing prices of the two stocks are shown in the table below.
| Date | IDEA* | RCOM* | Price Ratio |
| 06-Apr-09 | 53 | 218 | 4.09 |
| 08-Apr-09 | 55 | 214 | 3.88 |
| 09-Apr-09 | 55 | 212 | 3.84 |
| 13-Apr-09 | 55 | 219 | 3.98 |
| 15-Apr-09 | 57 | 230 | 4.03 |
| 16-Apr-09 | 53 | 218 | 4.12 |
| 17-Apr-09 | 54 | 218 | 4.04 |
| 20-Apr-09 | 56 | 216 | 3.86 |
| 21-Apr-09 | 58 | 219 | 3.74 |
| 22-Apr-09 | 57 | 214 | 3.76 |
| 23-Apr-09 | 58 | 224 | 3.86 |
| 24-Apr-09 | 61 | 232 | 3.84 |
| 27-Apr-09 | 60 | 224 | 3.75 |
| 28-Apr-09 | 59 | 208 | 3.55 |
| 29-Apr-09 | 58 | 215 | 3.70 |
| 04-May-09 | 63 | 229 | 3.66 |
| 05-May-09 | 61 | 237 | 3.86 |
| 06-May-09 | 60 | 235 | 3.94 |
| 07-May-09 | 60 | 240 | 3.99 |
| 08-May-09 | 59 | 230 | 3.89 |
| 11-May-09 | 58 | 219 | 3.81 |
| 12-May-09 | 61 | 228 | 3.74 |
| 13-May-09 | 60 | 223 | 3.73 |
| 14-May-09 | 60 | 225 | 3.72 |
| 15-May-09 | 65 | 233 | 3.57 |
| 18-May-09 | 76 | 290 | 3.82 |
| 19-May-09 | 76 | 316 | 4.19 |
| 20-May-09 | 73 | 309 | 4.26 |
| 21-May-09 | 69 | 324 | 4.71 |
| 22-May-09 | 71 | 316 | 4.43 |
| 25-May-09 | 73 | 322 | 4.41 |
| 26-May-09 | 70 | 291 | 4.15 |
| 27-May-09 | 79 | 304 | 3.86 |
| 28-May-09 | 79 | 298 | 3.77 |
| 29-May-09 | 84 | 306 | 3.63 |
| 01-Jun-09 | 82 | 321 | 3.90 |
| 02-Jun-09 | 81 | 320 | 3.97 |
| 03-Jun-09 | 81 | 333 | 4.10 |
| 04-Jun-09 | 82 | 343 | 4.19 |
| 05-Jun-09 | 83 | 340 | 4.10 |
| 08-Jun-09 | 78 | 309 | 3.96 |
| 09-Jun-09 | 83 | 333 | 4.03 |
| 10-Jun-09 | 83 | 350 | 4.24 |
| 11-Jun-09 | 87 | 347 | 3.99 |
| 12-Jun-09 | 83 | 332 | 3.99 |
| 15-Jun-09 | 83 | 319 | 3.85 |
| 16-Jun-09 | 86 | 328 | 3.80 |
| 17-Jun-09 | 81 | 309 | 3.82 |
| 18-Jun-09 | 78 | 299 | 3.83 |
| 19-Jun-09 | 80 | 305 | 3.80 |
| 22-Jun-09 | 79 | 296 | 3.76 |
| 23-Jun-09 | 78 | 296 | 3.78 |
| 24-Jun-09 | 82 | 302 | 3.70 |
| 25-Jun-09 | 79 | 300 | 3.78 |
| 26-Jun-09 | 80 | 312 | 3.93 |
| 29-Jun-09 | 78 | 307 | 3.96 |
| 30-Jun-09 | 71 | 289 | 4.06 |
| 01-Jul-09 | 74 | 299 | 4.02 |
| 02-Jul-09 | 74 | 293 | 3.95 |
| 03-Jul-09 | 74 | 293 | 3.93 |
| 06-Jul-09 | 69 | 269 | 3.88 |
| 07-Jul-09 | 73 | 264 | 3.64 |
| 08-Jul-09 | 69 | 255 | 3.67 |
| 09-Jul-09 | 70 | 256 | 3.67 |
| 10-Jul-09 | 68 | 243 | 3.59 |
| 13-Jul-09 | 65 | 237 | 3.63 |
| 14-Jul-09 | 68 | 249 | 3.65 |
| 15-Jul-09 | 73 | 262 | 3.58 |
| 16-Jul-09 | 72 | 270 | 3.77 |
| 17-Jul-09 | 74 | 273 | 3.69 |
| 20-Jul-09 | 75 | 270 | 3.59 |
| 21-Jul-09 | 76 | 268 | 3.52 |
| 22-Jul-09 | 75 | 262 | 3.51 |
| 23-Jul-09 | 78 | 275 | 3.52 |
| 24-Jul-09 | 82 | 276 | 3.39 |
| 27-Jul-09 | 80 | 282 | 3.53 |
| 28-Jul-09 | 78 | 291 | 3.73 |
| 29-Jul-09 | 76 | 283 | 3.72 |
| 30-Jul-09 | 76 | 282 | 3.71 |
| 31-Jul-09 | 79 | 276 | 3.49 |
| 03-Aug-09 | 80 | 290 | 3.64 |
| 04-Aug-09 | 79 | 282 | 3.59 |
| 05-Aug-09 | 78 | 280 | 3.59 |
| 06-Aug-09 | 76 | 270 | 3.55 |
| 07-Aug-09 | 73 | 255 | 3.49 |
| 10-Aug-09 | 74 | 252 | 3.42 |
| 11-Aug-09 | 75 | 253 | 3.39 |
| 12-Aug-09 | 76 | 256 | 3.39 |
| 13-Aug-09 | 78 | 265 | 3.39 |
| 14-Aug-09 | 78 | 259 | 3.31 |
| 17-Aug-09 | 77 | 245 | 3.39 |
* Figures have been rounded off
Using the above data and doing some basic calculations, one can obtain the following information:
|
| IDEA* | RCOM* | Price Ratio | ||
| As on Aug 17 ‘09 | 79 | 245 | 3.10 | - | - |
|
| AVERAGE | MIN | MAX | ||
| 90 days | 72 | 273 | 3.81 | 3.31 | 4.71 |
| 60 days | 77 | 290 | 3.76 | 3.31 | 4.41 |
| 45 days | 76 | 279 | 3.67 | 3.31 | 4.06 |
| 30 days | 75 | 267 | 3.57 | 3.31 | 3.88 |
* Figures have been rounded off for simplicity
The price ratio (RCOM/IDEA) has been in the range of 3.31 to 4.71 during a 90 days period. But based on closing price of August 17, 2009, the price ratio is 3.10. Taking the minimum past price average (during 90 days and 30 days periods) is 3.57 and current ratio is 3.10, which means that either - IDEA is overpriced and needs a revision of Rs. 10 (the corrected price should be Rs. 69) - or RCOM is underpriced by Rs.37, making it a buy with target price of Rs. 282.
Hence, based on the above statistical relation between the two stocks, I should buy RCOM with a target of Rs. 282 and sell IDEA with a target of Rs. 37.
Another variant of pair trading is through fundamental analysis. After careful and thorough analysis, an analyst gives an overvalued rating to Stock A and undervalued rating to Stock B. Using this strategy, he will go short (i.e. sell) on A and long (buy) on B.
But if a strategy has only a few calculations, why is it not being followed by all mathematicians and every trader and investor for that matter? Let us try to guess the obvious reasons. First, what if the empirical relation was just a coincidence and nothing else i.e. there was no relation as such among the two stock prices. Second, what if the market acted otherwise. Market Gurus say that this strategy is best suited for markets which move sideways, and not in an uptrend and downtrend. Reason? We are betting that one stock will go up and other down. In an uptrend it is quite possible that both stocks ride the price charts and reverse is also probable in a downtrend.
