Pairs trading is some of the techniques hedge funds use in order to make profit on the dynamics between two stocks. The basic idea behind is pretty simple. Let’s consider an example of two stocks that might be somewhat correlated. This could be two companies in the food industry or the computer industry that might be affected by the same economical changes. We will want to check if the price difference between the two remains in some constant interval. For example, we might see that the price of stock A minus the stock of stock B stays pretty much between $5-$10 .
How To Profit From This
Since we know the price differential remains pretty much constant in some range of prices, we’d be on the lookout if this pattern changes. If stock B for some reason went down and stock A went up and the price differential is now $20, we might argue this is an anomaly and we would bet it would go down to the 5$-10$ mark again. We would short sell stock A and buy stock B. We will be betting that the interval would come back down again. We will want to profit of the collapse of stock A and the rise of stock B.
This is not correlation
The subtle point to pay attention to is that this does NOT mean we look for stocks that are correlated. They should only remain in some constant price differential. This could mean that stock A might right and stock B might fall a bit but not enough to cause an anomaly in the price differential. This idea is called co-integration.
Statistical Arbitrage
These ideas are sometimes known as statistical arbitrage. The reason we bet that the price differential would come back would need to be backed up by some sort of statistical tests on historical prices. Moreover, we’d have to FIND those stocks that are co-integrated.
I’m going to put a program that would test for co-integration between two stocks later today so you could play around with it.
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