tactics
INTERMEDIATE
Pairs Trading Buying one index and selling another carries less risk than just buying or selling one index position outright By Michael Gough
T
urn on CNBC, Bloomberg, tastytrade or any other financial media outlet and a host or commentator will soon mention “the market.” Depending on the outlet, those well-coiffed personalities could be referring to any of the four major equity indices. In the U.S. they would be the S&P 500, Dow Jones Industrial Average, Russell 2000 or Nasdaq 100. Each of those indices represents a different portion of the equities market, but they all tend to move together. As of this writing, any pair of these indices has a six-month price correlation greater than 0.80, meaning they move in similar directions. These indices move closely because many of them hold the same stocks! Roughly 80% of the stocks in the Nasdaq are also in the S&P 500. Additionally, 100% of the stocks in the Dow are held in the S&P 500. The overlap results in the indices moving in similar ways, hence the strong price correlations. Take a look at “Trading by the pair” (right), which depicts the percentage change of ETFs (exchange-traded funds) representing the S&P 500 and the Dow since 2018. Note that most of the time the two products trade very closely. However, differences in performance between them occasionally increase. Pairs trading is a professional strategy that capitalizes on extreme divergences between highly correlated products. Unlike trading the price or vola-
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tility of a single underlying, a pairs trade exploits the relationship between two underlyings by selling the leading stock and buying the lagging stock. Pairs trading carries less risk than just buying or selling one underlying outright because losses in one position are often offset by gains in the other position in the correlated pair. Structuring a pairs trade The first step in structuring a pairs trade is finding two highly correlated assets. Some examples include gold and silver, the British pound and the euro, and the S&P 500 and the Dow. SPY and DIA are great candidates for a pairs trade because their six-month price correlation is 0.93, a strong positive correlation. A strong
The best entry points generally occur when assets have an extreme divergence in performance
Trading by the pair Most of the time these two products trades closely. However, differences in performance occasionally increase, and that’s when pairs trading can prove useful.
luckbox | july 2019
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6/7/19 10:05 AM
