A simple way to understand what Pairs Trading is all about is through the use of visual graphs. Let's start with the following generic chart that shows the performance of two different stocks over a 9 month period:

 

 

As you can see, these two stocks are tracking very closely to each other over a pretty decent period of time. Now let's take a look at another graph which shows the movement of these two stocks over the first month by week:

 

Notice how in chart 1 the two stocks are so closely tied together in movement. However, when looking at chart 2 you can see there is actually more underlying volatility on a shorter term basis. Refraining from using any math terms (which are too frequently used when describing things like this), it is also apparent in chart 2 that there are a couple of occasions where the stocks move away from each other a bit and then come back together. Viewing this type of pattern in charts 1 and 2 provide us with the foundation for a profitable pair trade. Let's go into some more detail to understand how this works.

Simply put, our goal is to take advantage of those "gaps" where two stocks move away from each other and profit when they come back together. Looking at chart 2, you can see in week 1 that there was a bigger gap between the two stocks than in week 2. Likewise, a gap existed in week 3 and then the two stocks crossed over between weeks 3 and 4. What if we were able to enter positions with these two stocks in the beginning of week 1 and then close both positions in the beginning of week 2 to take advantage of that gap closing up and make a profit? The way to enter such a position is by opening a "Pairs Trade" - which in this case means that we want to buy the stock that has under-performed and short sell the stock that has outperformed. When the two stocks come back together, we want to close the trade by selling the stock that we bought and by buying (to cover) the stock that we sold short. Here is how it works:

 

Week 1: We Open The Trade

Buy 'Stock B' at $48

Sell 'Stock A' at $50

 

Week 2: We Close The Trade

Sell 'Stock B' at $50.70

Buy 'Stock A' at $51

 

'Stock B' Profit => $50.70 - $48 = $2.70

'Stock A' Loss => $50 - $51 = ($1.00)

Total => $2.70 - $1.00 = $1.70

 

As you can see, we gained $2.70 on one stock and we actually lost $1.00 on the second stock. However, because the two stocks converged back our gains exceeded our losses. In Pairs Trading, every time your gap gets smaller from your opening trades to your closing trades you make money. Sometimes you make money on both stocks, and sometimes you make more money on one stock than you lose on the other. In either case, it's a winning trade.

So how do we identify the right pairs to trade? How do we know when to get in and get out of a pairs trade? To answer these two important questions involves a lot of math, along with an intimate understanding of market dynamics. To design a system to do this is complex and usually not practical for the individual or retail investor, and that is why large institutions hire teams of programmers and analysts to build an in-house application. Fortunately, companies like Keyon perform all of the research and do the leg work to provide the answers to both questions, to make it simple to understand and to enable you to execute. 

 

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