lecture23 - Lecture 23: Pairs Trading Steven Skiena...

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Lecture 23: Pairs Trading Steven Skiena Department of Computer Science State University of New York Stony Brook, NY 11794–4400 http://www.cs.sunysb.edu/ skiena
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Pairs Trading This strategy was pioneered by Nunzio Tartaglia’s quant group at Morgan Stanley in the 1980’s. It remains an important statistical arbitrage technique used by hedge funds. They found that certain securities were correlated in their day-to-day price movements. When a well established price correlation between A and B broke down, i.e. stock A traded up while B traded down, they would sell A and buy B , betting that the spread would eventually converge. This divergence between pairs may be caused by temporary supply/demand changes, when a single large investor changes position in a single security.
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Potentially Correlated Pairs Coca-Cola (KO) and Pepsi (PEP) Wal-Mart (WMT) and Target Corporation (TGT) Dell (DELL) and Hewlett-Packard (HPQ) Ford (F) and General Motors (GM) Highly-correlated pairs often (but not always) come from the same sector because they face similar systematic risks.
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Advantages of Pair Trading: Market Neutrality The pairs trade helps to hedge sector- and market-risk. If the market or sector crashes, you should experience a gain on the short position and a negating loss on the long position, leaving your profit close to zero in spite of the large move. In a pairs trade, you bet on the direction of the stocks relative to each other. Trading strategies which are independent of market move- ments are said to be market neutral . Pairs trading is a mean-reverting strategy, assuming that prices will revert to historical trends. Pairs trading is largely self-funding , since the short sale returns can be used to buy the long position.
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The increased divergence between two stocks can be a rational response to news about one of the companies. Transaction costs (e.g. commissions, bid-ask spreads) can eat up the theoretical returns in such an active strategy. Pairs trading became less advantagous as more groups started doing it. Hedge funds use algorithmic trading strategies that monitor for deviations in price, automatically buying and selling to capitalize on market inefficiencies. Such program trading requires fast reaction/execution time to
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lecture23 - Lecture 23: Pairs Trading Steven Skiena...

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