The Basics of Pairs Trading By Steve Slavin, Butler Wick & Co Institutional Markets Group A Brief Background • • • • • Outline for this Panel Discussion Steve Slavin, Co-Founder of PairTrader.com, PairCo, LLC, and PairCo Capital Holdings, LLC. Butler Wick & Co – Institutional Coverage (not only short sale focused) Early Institutional Trading – Looking for a way to get consistent, and in turn give up bigger P&L swings. Introduced to Mergers and Acquisitions and A/B spreads Hedging Types • • Pairs, Pair, Spreads, Stat Arb, Risk Arb Intercommodity Spreads • • • Long the 3/04 Euro, Short the 6/04 Euro Long Gold, Short Silver Intermarket Spreads • • Long S&P 500, Short the FTSE Bond Spreads – yield curve relationships • • Notes over bonds Municipals over bonds Other Hedging • Index Spreads Ex. .SPX/.SML (large cap/small cap) • Equity Spreads • Mergers and Acquisitions Ex. GE/HON – year 2001 Correlated Pairs Ex. C/JPM or MWD/MER Citigroup JP Morgan .8 C – 1.0 JPM C / JPM - ratio Pair Trading Present & Future… • Technology and low trading costs are allowing the more active investor and advisors to participate in this type of trading Spreads/Pairs continue to work well in current market environments • • • From bullish/bearish runs to long periods of range bound trading. However with market neutrality you usually under-perform significant bull bear markets, and instead opt for a more consistent and conservative approach. Pair Trading Present & Future… • Today’s environment emphasizes the need for market timing and risk control • Many noted economists and market timers are forecasting continued sideways action for years to come. Pair Concept of Correlation… • Correlation • Expansion from equities to sectors and indices. (can use as confirmation of rotation, etc) • Examples… SPY/QQQ, KO/PEP, CATDE .3 SPY – QQQ (daily) .3 SPY – QQQ (weekly) KO - PEP -- Pair KO – PEP (weekly) MWD – MER C – Notice the Trading Ranges = 25 pts JPM – Trading Range=28pts C – JPM – Ranges contained to 13 pts C / JPM – Ratio Chart Benefits to Market Neutrality • Market Neutrality / dollar neutrality – minimizing market risk • Typically smaller gains, but more predictable price action, and opportunity for greater consistency of profitability • Forces you to be patient, can lead to longer longevity as a trader or money manager • Allows for greater position size comfort, greater diversification – all while trading a spread number – not the individual stocks by themselves Benefits cont… • • • • • Opens the door to multifaceted strategies: 3, 4, 5 ways, leans, etc. overweight / underweight rather than long/short Often reduces the number of trades in the super short term – reducing costs, and reducing stress too. Pairs provide market opportunities in seemingly dull markets Benefits cont…. • Pairs offer a means to trade directionally in volatile markets • Works in any market, though will often lag in a very historically quick bullish or bearish environment Steps To Action… • You’ll need to find the pairs to trade by doing some simple research, (defining your universe) – define your criteria • You’ll need to chart out this correlation of stock prices over time and monitor them frequently (per your time horizon) Steps To Action…cont. • You’ll need to time your investment by using some simple rules • You’ll need to have a solid money management system in place that will enable you to stay comfortably leveraged or not, take gains at the right time, and cut losses when it’s warranted. What Are The Risks In Pair Investing? • Worse case scenarios always exist – disciplined money management is still very important. example. 9/11 • Pair trading still requires you to correctly analyze the probability of one stock outperforming the other – if you’re wrong, you will lose money. However, losses are typically minimized. Risks cont… • Relatively consistent range bound trading and adding to positions can cause a sense of security that isn’t always real. • What you see isn’t always what you get. Constructing a Trade… • Define your universe – screen for best pairs based on criteria you define • Define your fundamental biases and keep updating them • Ratios • Catalysts • Pay attention to earnings season • Monitor for situations where the technicals show historical anomalies or significant diversions from the norm – catalysts too. (Only trade when you have an edge). Constructing cont… • Remember, it’s okay to pair trade with a trend, but most look for reversion to the mean. • Timely execution of both sides is key. • As usual, disciplined money management is critical before and after the trade is placed. • How many can you trade at once? • • Depends on time frame Pros can daytrade 10-20 spreads intraday at a time, extend your time frame and you can certainly add more How This Product Is Different: • If you love a sector, at the very least it tells you what to avoid. • Ideas are frequent or few depending on your needs Further trade examples discussed later… Conclusion… Be more aware of correlation language in research. Remember with pairs you’re no longer trading the stocks individually. Don’t forget Fundamental Biases – they’re still important Trade only when you have an edge.