Pairs Trading

Pairs trading is a market neutral strategy, where a pair or a basket of stocks are selected and long position is taken on one leg and a short position on the another.

The strategy builds on mean reversion theory, which states that the price ratios of correlated/cointegrated stocks revert back to their long term mean after unexplained considerable deviations in the prices. In a pair, where the prices of its constituents generally move together and when one stock outperforms the other, the outperforming stock is sold (short position) and the underperforming stock is bought (long position) with an expectation that they will revert back to their mean.

Steps for pairs trading are as follows:

1. Make a  list of pairs which are highly correlated.

2. Check whether the  pair is co-integrated.

3. Decide on the time horizon of trade (hours, days, weeks, months).

4. Calculate the price ratio for the selected time horizon and then compute the standard deviation for that price ratio distribution. Subsequently calculate the z-score values for the price ratio distribution.

5. Based on the z-score, define pairs’ entry points for extreme z-score values.

6. If the pair ratio / z-score goes beyond a certain predefined threshold, then sell the winning stock and buy the losing stock.