A pairs trading investment strategy consists of a long position in one instrument matched with a short position in another. This is frequently performed with stocks. An example of a pairs trading strategy with ETF‘s might be the QQQ v’s the XLK although any pair of financial instruments is possible. These products are characterized by a high correlation but more importantly is the degree of co-integration. Another possible pair could be the IQ Merger Arbitrage ETF (MNA) and the ProShares Merger ETF (MRGR). However, as sufficient liquidity is required to make the trade successful, these ETF may not be viable. Spread betting, of financial betting may be a solution for the liquidity problem. Many traders in Europe use financial spread betting firms for currency pairs because of the tax free status of the profits.
The exact ratio between the two products in question is at the discretion of the trader. This may be calculated on a statistical basis using a lookback period of varying lengths. This lookback period is usually long enough to incorporate significant events, but short enough to be considered recent and use data which would not be considered out of date. Once the ration is established the trader can invest in the products and maintain a “dollar neutral” position.
This is similar to a merger arbitrage investment strategy when trading the merger spread in a stock deal. In this case, the exchange ratio is known and fixed. The trader opens a long and short position in the target and acquirer stock as necessary. Merger Arbitrage Limited often trades spreads for the proprietary account which exhibit high volatility in a scalping style strategy which we refer as “Active Arbitrage”.
Trading a Pairs Strategy
The strategy uses both statistical and technical analysis to identify potential pairs. The strategy is similar to Statistical Arbitrage but is not limited to the use of mathematical models. Traders often look for underling links between the two assets so as to avoid any chance or spurious relationships. An example would be Coca-Cola (KO) and Pepsi (PEP) although these companies are now diversified to the extent that the relationship has weakened in recent times.
Another example of a pairs trading strategy can be gold (the commodity) and a gold miners ETF. Ernest Chan in his book “Quantitative Trading: How to Build Your Own Algorithmic Trading Business” has a great description on the success and pitfalls of this particular strategy.
Additional factors traders must consider include the quality of the data. Are closing prices being used? Are the products sufficiently liquid to have reliable closing prices? What is the lookback period? This needs to be long enough to enable a walk forward analysis, but recent enough to capture the economic relationship that exists presently and not something that ceased to exist in the past.
