Pair trading pays in volatile markets

Volatility has become the hallmark of financial markets. We see benchmark indices posting decent gains in one trading session only to lose those gains the next day.

In such a scenario, traders and money managers can adopt a market-neutral strategy called pair trading, which is very popular with hedge funds, investment bankers and professional money managers. It is market-neutral as its profitability is not dependent on the direction of the market. It yields profits whether market moves up or down, or remains sideways. ALso, risk in this strategy is very low.

Pair trading strategy was designed by a team of scientists from different focus areas such as mathematics, computer sciences, physics, etc. who were brought together by the Wall Street quant Nunzio Tartaglia. In 1980s Gerald Bamberger popularised this strategy. He headed the team of quants at Morgan Stanley. His team, along with Nunzio Tartaglia, found that certain securities often competitors in the same sector were correlated in their day to day price movement.

Hence, any anomaly in the movement of two security prices, which are otherwise correlated, shall provide an opportunity to trade. When the correlation broke down i.e. when stocks started moving in the opposite direction for a while, he use to initiate trades by shorting the outperformer and simultaneously, he used to buy the underperformer.

By doing so, he is betting that the two securities in future shall converge and again start moving in the same direction. In this manner, he struck gold for his firm. However, the origins of pair trading strategy can be traced to the world’s first hedge fund, established by Alfred Winslow Jones in 1949. It is said Jones effectively implemented this strategy by creating long and short positions simultaneously and made decent money for his fund.

To effectively trade with the help of pair strategy what we have to do is: 

Identify two scrips from the same sector which are highly correlated in their movement

Watch whenever these two scrips start moving in different directions; once the deviation crosses the threshold limit, initiate a trade

Out of the two, buy the scrip which has underperformed and simultaneously initiate short position in the scrip which has outperformed 

Book profits when the price ratio of the two scrips converges
The beauty of pairs trading lies not in betting in the direction of the market, but betting for the convergence of the price ratio between the two scrips which are highly correlated.

For instance, let us assume that Infosys and Wipro are correlated. It means most of the times these two scrips move in tandem with each other either in upward direction or downward direction.

Some times due to different reasons, their correlation breaks they behave abnormally by moving in different directions. This movement gives an opportunity to trade.

If Infy has outperformed then initiate short positions and simultaneously create long positions in Wipro. Eventually, the outperformer has to correct and the underperformer has to catch up. When the price ratio of the two scrips converges, book profits. In this fashion you can make money from both the trades.

The writer is technical analyst, Darashaw & Co, Mumbai. Views are personal