You would notice that interstate highways usually include the main highway. This is where the cars zoom past at top speed. It is not uncommon to see a single road on either side of an interstate highway. This road is sometimes called the service road. This road allows private driveways, shops and houses to access the service road. These service roads are also called the local-express lanes. For the whole length of the highway, the service road and highway run usually parallel to one another.
Imagine this: A new highway and service road are being built. The highway contractor has stated that the highway and the service road will be laid. The contractor comes across a tiny tree while laying the new service road. The road contractor, however, decides to not cut the tree, but to circumvent it by making a slight deviation from the tree, and then getting back on track to run parallel with the highway.
This is how the road is built and then people use it. How do you interpret it?
The two roads run parallel for the entire stretch, if you think about it. If the highway is inclined at any point, the service road will follow suit. The service road would also be affected if the highway went down. The service road would also be affected if the highway crosses a river. And so on. The two roads behave almost identically for practical purposes. Except at the point when the tree temporarily blocked the path on the service side road.
Let's go one step further. Let's break it down into variables.
This is a strange analogy. But if you can imagine the highway, the service road and the tree and the parallel relationships between them, you will be able to understand the core philosophy behind pair trading.
Let me try to do this.
Just like the roads or entities, i.e. the highway and the service road, think of two similar companies, let's take HDFC Bank (or ICICI Bank).
You will also find the examples of Coca-Cola or Pepsi in any book on Pair Trading. Let's move on to HDFC and ICICI, as they aren't listed in India.
And so on.
Due to the striking similarities between these two banks, any change in the business environment should affect the 2 and 3 banks in the same manner. If RBI raises interest rates, both banks will be affected in the same manner.
We can now define -
Conclusion from the following -
This can be summed up as:
Because of the established relationship between the companies, entity 1's stock price is expected to move in the same direction as entity 2. If not, there may be a trading opportunity.
If ICICI stock prices rise by X% on a given day, then HDFC's stock price is expected to rise at least y%. However, let us assume that HDFC remained flat. We can then claim that ICICI stock has moved higher than we expected compared to HDFC stock price.
Arbitrage is the act of buying the cheapest stock, i.e HDFC, and selling the more expensive stock, i.e ICICI.
This is the core and purpose for "Pair Trading".
Wait a minute - what about that tree on the service road? And its significance to the entire narration? You may recall the tree that caused an anomaly within the otherwise perfect "parallel” relationship between the roads.
In a similar fashion, even if the stock prices of both companies are in a perfect relationship, an event could cause a price anomaly. Stock 1's price can differ from stock 2's.
A stock price anomaly gives us the opportunity to trade. An anomaly could be caused by anything.
A price anomaly, as it is commonly known, is an event that causes the stock prices of one company to react (or overreact) differently than the other. It is a local event, as it only affects one company out of our two stocks.
The relationship is what sets the rules for how the stock prices relate. The bulk of pair trading is therefore based on -
These relationships can be defined in many ways between stocks. These two techniques are popular because they use-
These techniques are very different. Both of these techniques will be discussed in Varsity.
A quick overview of the history and development of Pair trading before we close this chapter.
Morgan Stanley executed the first pair trade in the 80's, by Gerry Bamberger, a trader. Gerry, a trader named Gerry Bamberger, was the one who discovered the technique. He kept it secret for many years until Nunzio Tartaglia (again from Morgan Stanley) popularized it.
Nunzio was a pioneer in Wall Street's 'Quant trading' and enjoyed a large following at the time. He was actually the head of Morgan Stanley's prop trading desk during the 1980's.
This strategy was adopted by DE Shaw, the famous Hedge Fund.
Pair trading, as you might have guessed requires you to simultaneously buy and sell two stocks/assets/indices. Pair trading is considered a neutral strategy by many. Because you can trade both long and short simultaneously, it is market neutral. This is grossly incorrect, as you are both long and short in two stocks.
Market neutrality means that you can be both long and short on the same underlying at the same moment. The calendar spread is a good example. A calendar spread is where you can be both long and short on the same underwriting expiring at two different dates.
Please don't assume that pair trading is market neutral. This strategy seeks to profit from price differentials between related assets.
We are trying to make a profit on the "relative values" of both the assets by simultaneously selling and buying them. Pair trading is termed as "Relative Value Trading".
This is an arbitrage opportunity in its purest sense. We buy the undervalued security, and we sell the overvalued one. This is sometimes called statistical arbitrage.
How to measure the 'undervalued’ or 'overvalued? This is always done with regard to each other. We'll be learning this measurement technique in the next chapter.