Last month I gave a presentation where I shared several of the best options trading strategies I ever learned from my years on the Nasdaq-PHLX floor. There was considerable interest among those in attendance that day in details about executing pairs trading strategies. Accordingly, in this article I’ll share some key terms one must know to truly understand how to win. Also, I’ll give some personal insight into this relatively simple to execute (but often butchered) options trading strategy.

What Is Correlation?

A brief lesson on pairs trading and a discussion of some key related terms is in order for those hearing about the strategy for the first time. One must understand correlation to know how to trade a pairs strategy. Correlation is a mathematically discernible relationship between two (or more) products. This relationship is measured within a range of negative (-1) to positive (+1). It is generally measured on a historical basis with a minimum of one month (longer is better).

Correlation measures the rate at which two assets have tended to behave in relation to their mean (remember mean, median and mode?). If the two products included in your pair are normally on opposite sides of the mean, they tend to move in opposite directions and have a negative correlation (-1). If they are normally on the same side of the mean, they tend to move in the same direction and have a positive correlation (+1). If there is no clear trend, they are said to have little to no correlation (0).

Pairs Trading Breakdown

A pairs trade strategy was first developed in the 1980s by quants at Morgan Stanley. They determined it was a profitable strategy to bet based on the historical correlation of two securities; the securities in a pairs trade must have a high positive correlation, which is the primary driver behind the strategy’s profits. This is mainly thought of, and then executed as, a market-neutral strategy, meaning the two offsetting positions form the basis for a hedging strategy that seeks to benefit from either a positive or negative trend.

Succinctly put, a trader seeks to profit when a discrepancy occurs in the correlation between two highly correlated assets. Relying on the historical notion that the two securities will maintain a specified correlation, a trade can be executed when this correlation falters, since it is anticipated that the correlation breakdown between the pair is temporary.

When pairs from the trade eventually deviate — as long as a pairs trade strategy is in use — the investor would seek to take an equal dollar-matched long position in the underperforming security and sell short an equal dollar-matched position in the outperforming security. If the securities return to their historical correlation, a profit is made from the convergence of the prices and subsequent unwind. I underlined the words “equal dollar-matched” twice in this paragraph for a reason. A lot of folks who jump into this strategy forget they need to create an “apples to apples” ratio of risk capital allocation when executing. This usually means buying fewer shares of one of the two equities in the pair.

For example, to properly execute the pairs trade in the ever-popular Coke vs. Pepsi pairs trade, one must buy almost 3 shares of Coca-Cola Co. (KO) for $54.10 a piece, versus selling only 1 share of PepsiCo, Inc. (PEP), whose share price is $148.35.

Pairs Trading Pitfalls

Important to include in this article are several limitations for pairs trading. First, a pairs trade relies on a high statistical correlation between two securities. Most pairs trades will require a correlation of 0.80, which can be challenging to identify. Second, while historical trends can be accurate, past prices are not always indicative of future trends. Requiring only a correlation of 0.80 can also decrease the likelihood of the expected outcome. Third, executing the strategy correctly is required in order to profit (at least most of the time anyhow).

Final Thoughts

It is well understood that including pairs trading in a portfolio diversifies risk and decreases overall risk exposure. Pairs trading strategies are generally not adversely affected by periods of low implied volatility, allowing for profiting from the somewhat predictable cyclicality of the markets. Retail traders, just like their institutional cohorts, may benefit from allocating at least a portion of their efforts to pairs trading.

Joe Leska, Market Taker Mentoring