Pair Trading Educational Course – Part 1
Contrary to popular belief the market has logic to it. The market is efficient most of the time, which is stocks are priced accurately according to all the known and forecast information. The truest logic running through markets is that of relative value, all assets are worth something in relation to something else. Take gold for example; when you buy gold you are going short the dollar too. Stocks, when you buy stocks you are going short cash. Stocks, bonds, commodities & currencies are all inter-related markets with different themes running through them at any given time. The price of oil directly affects the profits of oil companies, hence a correlation between oil futures and oil stocks. Generally the stock market is a forecasting barometer for how the economy will perform over the next 6-12months. That’s why stocks markets always bottom before the economy does and vice versa for topping. Consider the market a big voting machine that represents the collective forecasts of every market participant. Then within the market are different industries, they are priced for their expected growth rates too, then finally within each industry stocks are priced for their individual growth prospects. Generally speaking stocks within the same industry have similar valuations; if one stock is expected to grow a lot more than another stock you will find however it has a higher valuation, a higher P/E. The stock market as a whole is affected by interest rates set by central banks, thats why they respond dramatically to changes in the expected interest rates. Many stock valuation models incorporate the risk free rate of return on government bonds. If bonds are yielding 10% stocks have to be growing significantly for them to be cheap relative to the risk free rate of return. If interest rates are 1% stocks don’t have to be so cheap to seem like a good buy. As you can see the markets are all connected and related to one another in some shape or form. What about one stock relative to another? Let’s take Coca Cola and Pepsi traded on the NYSE as an example. Both operate in the non-alcoholic beverages market, they share the same demographic, distribute similar products and will be affected by the same macro-economic
and macro-industry conditions, therefore both these stocks receive similar valuations and move in a similar fashion. Look at the chart below which shows the stock prices of KO & PEP.
Notice anything here? Yes, they move very closely to one another. There is a scientifically proven relationship between these 2 stocks. There is stock price correlation of 90%. Most of the time these stocks will move in the same fashion, however every now and then they will diverge from one another. This presents a trading opportunity. Because each stock has different institutional shareholders who trade the majority of stock trading volume, they each have their own agenda’s, investment mandates and digest and respond to information differently. Every now and then the institutions will offload a lot of shares or acquire a lot of shares in one stock, thus moving the stock. If they don’t trade in the other stock it won’t move, but that’s where we the traders come in. We arbitrage this opportunity away, by buying/selling the other share to be more in line with the one that has moved, by doing this we provide liquidity to the market, aide in price discovery and aide in pricing assets correctly using the theory of relative value. Therefore there is value to pair trading, we perform a necessary function to the efficiency of the marketplace. We also take an opposing position in the first stock so we remain market and sector neutral, that is general market and sector movements won’t affect our overall position. We are only left we stock-specific risk, that is a event happening that only affects one stock, not the market or an industry as a whole. We mitigate the risk of the unknown future stock specific event...
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