The Basics of
Pairs Trading
By Steve Slavin, Butler Wick & Co
Institutional Markets Group
A Brief Background
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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
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Pairs, Pair, Spreads, Stat Arb, Risk Arb
Intercommodity Spreads
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Long the 3/04 Euro, Short the 6/04 Euro
Long Gold, Short Silver
Intermarket Spreads
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Long S&P 500, Short the FTSE
Bond Spreads – yield curve relationships
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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…
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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
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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…
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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….
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Pairs offer a means to trade directionally in
volatile markets
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Works in any market, though will often lag
in a very historically quick bullish or bearish
environment
Steps To Action…
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You’ll need to find the pairs to trade by doing some
simple research, (defining your universe) – define
your criteria
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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?
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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.
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