Best Practices

Pairs Trading

| Nov 10, 2014
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    Best Practices

    Pairs Trading

    Nov 10, 2014

    One way that we can reduce risk when trading is to place a pairs trade. Here, we are looking at placing a simultaneous position in two underlyings that are highly correlated. When trading pairs, we look for the correlated underlyings to reach an extreme relative to each other. This could mean that two underlyings that normally move in the same direction currently are diverting. Here we will place a trade that will look for the pair to come back in line and trend in the same direction.

    Today, Tom Sosnoff and Tony Battista explain how to set up a pairs trade. They make the case that pairs trading is slightly less risky than trading single underlyings. While losses are possible, they’re far less likely than due to the offsetting positions. Next, the boys go into some detail on correlations as the main parameter for our pairs trades. The correlation of two underlyings will always sit between -1 and 1, representing how much two underlyings tend to differ from their averages together (correlation closer to 1), oppositely (correlation close to -1) and independently (closer to 0). To provide some context, the team presents two tables (30 days and 200 days) with current correlations on the top five holdings of the Nasdaq-100 exchange traded fund (ETF).

    Next, the guys move into discussing the reasons why we enter pairs trades, primarily when correlated underlyings have seen a recent divergence. Once we’ve identified a pair, we then determine the ratio in which to trade these two underlyings. We generally trade pairs on a notionally adjusted basis. This means that we are looking to trade the two underlyings at an equal dollar amount. In the example provided, 100 shares of Google (GOOG) have a notional value of $53,968 - so to pairs trade it against the Nasdaq-100 ETF (QQQ), we need to trade 532 shares to get an equivalent ratio.

    This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.

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