A previous post has outlined the opportunities available through pairs trading.  Pairs trading allows you to profit from relative price movements between correlated securities as they become decorrelated, and then reconverge.  You purchase one security whilst short selling the other (note: there are restrictions on short selling stocks).  This is a market neutral strategy - it doesn’t matter what the market does as a whole - money is made by the convergence.

The difficulty to date has been the enormous computational effort of calculating correlations and then looking for divergences, but by chance, I found a product that already provides this information (I am not associated with it in any way).  The rest of this article outlines where you can get this, and a quick guide to using this data for profit.

CSI Data calculates correlations between securities, including stocks and futures.  This means that correlations between each stock and futures contract are calculated - some 50 billion calculations.  CSI Data then uses a proprietary statistical technique to identify divergences which are potentially tradeable.  

With pairs trading, it is possible to identify spurious correlations.  For example, GE may end up being correlated with a food manufacturer, but this doesn’t mean that there is actually a relationship.  Generally it makes more sense to look at correlations between related securities.  For stocks, a correlated pair may be GM and Ford, or in futures, gold and silver.  

Similarly, a pair may have been correlated, but simply diverge when you place a trade (instead of converging).

You need to be able to determine when the enter the trade (after using the CSI Data as a starting point), when to exit the trade at a profit, or exit at a loss.  

The CSI Data report doesn’t identify whether the correlation should be traded - it is simply a starting point.  You need to place the trade yourself after you have made up your own mind.  Nevertheless, they do the “heavy lifting” by doing a large number of calculations every day.  Unless you have a supercomputer, you won’t be able to do these yourself in a reasonable time, even if you have the data, and the proprietary study is an extra value add.

If you are interested in pairs trading, then this is something that is worth looking at as the service is reasonably priced.  Check it out here.

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Tags: pairs trading

This entry was posted on Thursday, October 9th, 2008 at 9:27 am and is filed under Hedge Funds. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.