Pair Trade: Trade outperformance + Reduce big market fall risk: Shubham Agarwal

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The time could not be better when the Nifty struggles above 19,000. This could create a bit of nervousness among all of us traders while taking directional trade. When the trend stops for a bit then we realize how far up we have come.

Again, a lot of traders prefer to reduce positions but instead what is easier is to get into Outperformance Trading via Pair Trades. Pair Trades or Long-Short is a trading strategy involving 2 stocks where we would buy one stock and sell one stock. With futures both of these trades can be easily placed. Let us understand Why and How of Pair Trading.

Why Trade in Pairs?

Simple answer is for risk removal. As the title suggests Pair Trades help us reduce risk of big market fall. We can understand this if we look at the risks faced by stocks.

Every Stock face 2 Kinds of Risks

Systematic Risk: Risk Posed by Factors affecting Country or Sector as whole (Policy Decisions, Interest Rates, Geo-Political Risks).

Unsystematic Risk: Company Specific Risks (Risks like Result Miss, Fire at Plant etc).

We will talk about mitigating Systematic Risk using Pair Trading. With Futures it is very easy. Imagine there is Interest Rate Hike. This hurts the Financial Institutions. To remove this risk, we can create a Pair of Buy & Sell positions in Futures.

Buy a Financial Institution Future

+

Sell another Financial Institution Future

Factors positive for both or negative for both will have very little impact on your Profit/Loss because they will get neutralized. Pairs Trading is a trading technique aimed at removing systematic risks popularized in 1990s in the world of Financial Derivatives.

With the struggle around higher levels, these are times when one wants to Buy for Outperformance and Not Bargain Hunting. Stocks that either runs faster or falls least.

How to Trade in Pairs?

As usual we always have a stock that we would want to Buy. Just add a few steps to this and get yourself a Pair.

Find another Stock from the same line of business that,

1. Has Highs and Lows are around the same period as Our Stock in past

2. Has outperformed (Risen more / Fallen Less) Our Stock in recent past (around a month)

Then we just Buy Our Stock, Sell the Stock found that satisfies above mentioned 2 conditions. Let us see how we manage this.

We would anyways have a stop loss on Our Stock. Just keep that stop loss in mind. If the stop loss gets triggered , get out of the entire Pair. If the trade works out and Our Stock heads up and hits the target, then the Profit could be a little less because the stock we sold may also go up.

However, my experience is that generally in the process of Pair Trading the money lost is small so if the outperformance comes in and we do hit the target, it would give fantastic reward for the risk taken.