Pairs Trading - Level 0 understanding
Luminous Logic provides an example and a very very high level overview of pairs trading. The basic idea is presented below:
1. Find a pair of stocks (or ETFs) whose prices tend to move together.
2. If the price movements are indeed highly correlated, then on most days the price per share of Stock A divided by the price per share of Stock B should come out to be about the same number, within a small range.
3. But occasionally, you might notice a significant divergence from this “average” ratio. If you do, enter a pairs trade. This will involve simultaneously shorting one of the stocks while taking a long position in the other.
4. At some time in the future when the price ratio (hopefully) reverts to the mean, exit the pair trade.
So the basic idea is that the price ratio reverts to a mean. We’ll test this hypothesis with some numbers in the next post.
1 year ago