Execution of Pairs Trading Strategy: Some Propositions

Abstract

Stock prices are subject to both systematic risk and unsystematic risk. While unsystematic risk can be reduced to some extent by portfolio diversification, systematic risk is external to a firm and in a sense reflects market sentiment and the existing macroeconomic condition. In this paper we ask the question, is there some way in which savers/traders could control this latter risk and still expect reasonable returns from the market? The answer lies in Pairs Trading which involves trading the ratio of prices of two stocks which belong to the same sector and whose prices are highly correlated. Ideally, the ratio of the price of the two such stocks should be steady. However, given the inherent randomness of stock price movements, this ratio tends to fluctuate. The fundamental basis of Pairs Trading is that although there would be fluctuations in the ratio of the prices, this ratio would be mean reverting. Thus if the ratio rises the trading strategy would be to short the faster moving stock and long the slower moving stock. This paper is written from the trading point of view. It differs from the existing literature as it provides a framework for a trader to profit in the short run by using technical analysis. The three technical indicators that we use in our study are Momentum, Bollinger Band and Moving Average Convergence Divergence (MACD).