Pair trading adventure I

It's been an exciting week doing more pair trading in the US stocks market and milking little gains from the market (I won't wear a bigger hat than my head even on margin). The most volatile counter played, no doubt, is Alibaba and I am out of it. Just look at the long long candle yesterday, woah.... Invincible, no other counter can be its pair now.

I know in one of my earlier posts I mentioned why I won't invest in oversea market - but now I ate my words? That is because three of the deterring factors are no longer bothering me (that much). First, the commission - my trade commissions for US stocks are lower than my buying of local stocks using Vickers. Second, custody fees - my position are not long term, so I am not sure how much custody fee would I be charged, however it is quite negligible (0.12% P.A). Third, foreign exchange spread - I am trading using account dominated in USD so I don't have to pay any fx spread for every trade executed (that's until when I need to withdraw the USD out to my local bank account).


My latest pair trade is on some pretty hot tech stocks. Shorted the one that was super over-valued but somehow market sentiment and TA would not succumb to FA's rationale, thus I got stopped out overnight and with 3 partial fills (dammit). The one I longed released good earnings so I have decided to just let it run till it exhausts its steam using a trailing stop loss.

The trailing stop loss function is really useful for overnight trades. It serves to lock in profit should the stock price decides to reverse course. In the worse case scenario, I will break even. The screenshot from SAXO below demonstrates how to set it up on an open position.

Right click on the open position and select 'Modify Related Orders'

In pair trading, the logic is that 2 stocks that are closely correlated in price movements would eventually 'close the gap' should they deviate from each other. So after opening a position, I just sit and watch the tug-o-war. However in my case here, both were on a short-term bull run. That over-valued stock, instead of closing the gap down, it moved further up yesterday. Oh well... a very good lesson learnt.

Top-most chart showing the price movements, bottom-most chart showing the 10-day correlation

Why I did choose pair trading out of all the strategies out there?

Because it can hedge my positions against the broad market movements (whether in up or down trend) should any unforeseen event happens. With the hedge and appropriate stop loss measures, I can allow myself a longer time frame of 1 to 2 weeks for a trade without having myself tied to the screen.


Is pair trading easy-peasy?

The concept of it is quite easy to understand but the whole trade set up takes much time and effort. The execution itself takes gut and discipline.

You will first need to spot 2 closely correlated stocks ,which are often in the same industry. They need to show enough volatility to make good profits yet not swing too wildly inter-days, and I prefer those that are more closely priced (for ease of sizing and profitability calculation). If a stock of interest has been swinging wildly inter-day, you might want to find out what caused it. Short squeeze is not fun. You will need to be alert to all recent news pertaining those stocks, including recent earnings, posted earnings, earning release date etc (the time consuming part). Where to put the stop losses and when to reap the profits are like art and science fit for a whole topic by themselves - I am still not learned enough to blog about them at this point.

I would say that trading requires a very different mind set from long-term investing. [Related post: First successful pair trade on SAXO]

"Pairs trading or pair trading is a long-short, ideally market-neutral strategy enabling traders to profit from transient discrepancies in relative value of close substitutes. Unlike in the case of classic arbitrage, in case of pairs trading, the law of one price cannot guarantee convergence of prices. This is especially true when the strategy is applied to individual stocks – these imperfect substitutes can in fact diverge indefinitely. In theory the long-short nature of the strategy should make it work regardless of the stock market direction. In practice, execution risk, persistent and large divergences, as well as a decline in volatility can make this strategy unprofitable for long periods of time (e.g. 2004-7). It belongs to wider categories of statistical arbitrage, convergence trading, and relative value strategies." Source

The main advantage of using pair trade is that we can set our stop loss points further away due to the theoretical reduction in risk from major price fluctuations as the positions are hedge for each other. 

So under what circumstances does pair trading fail?

Scenario 1

1. You opened both trades at the same time - one long, one short position.

2. The long position went down, the short position went up.

3. You got whip-saw stopped out. Case closed.

Scenario 2

1. You opened both trades at the same time - one long, one short position.

2. The long position gets profit stopped out.

3. The short position reversed course and went up (profit loss) before you could manually close it in time.

%@^&*#

Scenario 3

1. You opened both trades at the same time - one long, one short position.

2. After a week, the tug-o-war stayed the same. A perfect hedge.

3. Net loss from paying daily interest in CFD.

Here's some words of caution - quick gains are always tempting, but take only calculated risk.

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