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The Pairtrade strategy is an example of the so-called "statistical arbitrage" trading strategies that are employed by sophisticated institutional traders to consistently make money in financial markets. In this classroom we describe the basic concept of the Pairtrade. |
Content Highlights:
1. What is a market neutral trading strategy?
2. What is a Pairtrade?
3. How do I Back Test the Pairtrades at Tradetrek.com?
What is a market neutral trading strategy?
Under most circumstances one cannot be sure about the direction of the market (e.g., Dow Jones, NASDAQ, S&P 500 index, etc.), especially in the short term. A "market neutral trade" is a trade that does not get affected by the movement of the market as a whole: it is a trade that does not lose (or make) money simply because the overall market moves up or down. Through research on individual companies, you can gain views about the strengths and weaknesses of individual stocks. With this knowledge, you can implement "market neutral trading strategies" by buying stronger stocks and selling short weaker stocks. If you buy a certain number of shares of a stock and, at the same time, sell an appropriately chosen number of shares of another related stock, you can create a "market neutral" position that is hedged (i.e., immune) against uncertain market movements. If the market as a whole goes down a lot, you will most likely lose money from the stock you bought but make money from the stock you sold; if the market as a whole goes up a lot, you will most likely make money from the stock you bought but lose money from the stock you sold. The idea is that if you choose the stocks and the numbers of shares (that you buy and sell) appropriately, the gains and the losses due to the movements of the market overall offset each other.
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What is a Pairtrade?
A Pairtrade is a special case of a market neutral trade. In a Pairtrade, you buy (go long) a stock, and, at the same time, you sell (go short) another stock, believing that the stock you go long is relatively stronger than the stock you go short. If the market goes up, you make money from the long stock and lose money from the short stock. If the market goes down, the opposite occurs: you make money from the short stock and lose money from the long stock. In either case, you are hedged against sharp market movements (up or down). A Pairtrade tries to capture the relative value between two stocks: in a down market, you expect the stock that you buy to drop less than the stock that you sell; in an up market, you expect the stock that you buy to move up more than the stock you sell. In either case, if the analysis of the individual stocks is correct, the trade results in a net profit without exposing you to the risk of overall market movement. Tradetrek has developed two types of Pairtrades, the Convergence and the Divergence; please visit our other Web Classroom sections that cover these subjects.
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How do I Back Test the Pairtrades at Tradetrek.com?
Tradetrek.com records both Convergence and Divergence Pairtrades picked at the close of market everyday by the Pairtrade Live Picks engine. We provide a convenient Back Test tool for you to find out how the Pairtrades actually worked in the days after they were picked. The Back Test tool is listed under "Tools/Pairtrade Back Test" on the horizontal navigation bar. Click on it, you will arrive at the Pairtrade Back Test page shown in Figure 3.
Figure 3. Pairtrade Back Test page
Now you can pick a date and click on "Find Picks" to retrieve the pairs picked on that date. For example, let us get picks for 4/4/2001. You can test a particular Pairtrade by clicking on the symbols of stock pairs, such as "KRB-MEL" under Divergence Pairs. Then you will arrive at the Pairtrade Back Test Chart as shown in Figure 4.
Figure 4. Pairtrade Back Test Chart
Now you can click on the "Next Day button" to see how the trade performed after April 4th, 2001.
In the same way, you can Back Test Convergence Pairtrades by clicking on one of them on the page shown in Figure 3.
As you successively click on the "Next Day" button, you will either make money as the Tracker reaches the green line, lose money as the tracker drops down to the red line, or the trade will "expire" after 5 days if the tracker still remains between the green and the red lines. If the tracker reaches 2/3 of the profit targets, and then it drops back to below the entry level, a small circle will also appear on the Tracker that reminds you of the rule that "you should not let a winner turn a loser." A little circle will always appear on the tracker to remind you whenever the trade is to be concluded.
Please read on to learn more about the specific kinds of Pairtrades, Convergence and Divergence.
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