Whilst hedge funds have recently got some bad press due to the collapse of some funds that hold illiquid securities, wealthy investors still reap huge annual profits from the many sound hedge funds.  This article is about a hedge fund trading technique called pairs trading, or statistical arbitrage, and how you can use it to profit in your own trading.

Hedge funds don’t make billions of dollars by following the herd.  They can afford to pay the best minds in the business to develop new approaches.  One technique that has become known is pair trading, or statistical arbitrage.  This is a market neutral technique (this means that the returns are not correlated with the overall direction of the market).  It isn’t that different from a spread position in futures.

Pairs trading works by establishing a correlated relationship.  This means finding two securities (often shares) that move in the same direction.  This can be in the same industry, or across industries.  The assumption then is that if two securities are correlated, then if they diverge at a particular point in time, it is likely that they will converge again (since they are correlated in the long term).

So when they diverge to a certain point, you sell the one that has increased in value, and buy the one that has decreased in value.  Once they converge again, you close out the trade and profit from both the short sale and the buy transactions.

This is market neutral because it doesn’t matter what the market as a whole does.  The relative price movements between the two securities is all that is important.

The major risk in this technique is that the correlation no longer holds, and the pair continues to diverge.  This risk can be minimised by careful identification of the pairs.  For example, if you find a perfect correlation between a mining equipment manufacturer and a fashion house, you may need to make a decision on whether the correlation is spurious.  A correlation between two car manufacturers, such as Ford and GM makes more sense.

To trade pairs, firstly you need to identify correlations.  As mentioned, you can look within an industry, or even with an index like the DJIA (20 stocks) and a stock in that index.  You could also run correlations across pairs automatically, but this takes a lot of computer power to do this.  A hedge fund has the capability of doing this.

Then you need to identify a situation where the pair has diverged by an amount that would return you a worthwhile profit.

The important thing here is to find the point where the pair is starting to converge again.  To do this, you could smooth the price data from each security and look at the trend changes, or you could assume that the pairs will converge once the prices diverge (say) 2.5 standard deviations from the mean.

The next step is to place a long and a short trade.  You should preferably use derivatives to do this because this enhances your leverage.  You will need to place stop losses for both trades in case the pair keeps diverging.  You can determine the stop loss by finding the point where statistically the pair has gone outside of the normal divergence.  Again, you will need to use standard deviations to measure this.

Once the pair converges again, you will be able to close out the trades for a profit.

This article has outlined some of the potential of a trading technique used by hedge funds.  They have their own proprietary variations to this now, but it can be a sound approach that maximises your profit opportunity whilst “hedging” out market risk.  This is my favourite book on the subject: Pairs Trading Quantitative Methods and Analysis by Ganapathy Vidyamurthy and you can read a preview by clicking on the link.

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Tags: hedge fund, pairs trading, statistical arbitrage

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