Pairs Trading Revisited

To pair trade equities, I seek highly correlated stocks in the same sector. When I spot a deviation from the historical correlation, I might transact, seeking to profit on a correction of the deviation.

For instance, if Goldman Sachs (GS) and Bank of America (BAC) are trending over the same path over a period of time and I spot a deviation in one’s path, I might sell GS short, and buy BAC, seeking to capitalize on the fact that GS might be perceived as overvalued, and BAC might be perceived as undervalued. Thus, I am using both technical analysis and fundamental analysis in this strategy.

If GS decreases in price and BAC increases in price, I cash in my gains based on a pre-determined profit target, or cut my losses based on a pre-determined stop-loss threshold. I rarely “pair trade” on as an intra-day basis, my holding period is usually a few days.

I also might spot a trend with an exchange traded fund. For example, I might buy the Financial Select Sector Spider (XLF), and short Goldman Sachs, similar to the above mentioned scenario.

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1 Comment

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One response to “Pairs Trading Revisited

  1. I’m wondering if this is practical using Synthetic stock, particularly split strike synthetic stocks in pairs trading.

    I did some back-tests on baskets of ETFs held long versus a near identical basket held short, except a small percent of the basket that was performing the best was removed from the short basket. Still 50% long and 50% short though.

    I found that I could get it to very high Risk vs Reward ratios. However I don’t have much access to leverage myself, and the reward was low.

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