Pair Trading – Explained

Ram and Sam are twin brothers. They live in a house which is G+2 floors. The time is 8:20 in the morning and both are having breakfast in ground floor. Sam finishes eating his breakfast much earlier than Ram, post finishing his breakfast Sam leaves to second floor to pick his phone, so that he can talk to his girlfriend. Ram is a slow eater but he finishes his breakfast by 8:40 A.M., both Ram and Sam study in same school and both belong to same section. They have their online class at 9 A.M. in the morning and the computer used to attend online class is in first floor. At 8:40 A.M. Ram is in ground floor and Sam is in second floor. When the clock hits 9:00 A.M. both are in first floor to attend their online class.

Well, now assume Ram and Sam to be two companies that operate in the same segment. As a trader you might be interested in trading Ram and Sam. At 8:40 A.M. you buy Ram and sell Sam simultaneously. At 9:00 A.M. you close your position by selling Ram and buying Sam. Ram moved from ground floor to first floor so that’s your profit. Sam moved from second floor to first floor, as you’ve shorted Sam the difference of 1 floor is your profit. This is called Pair Trading. Basically, you go long in undervalued stock and short overvalued stock.

How is this done in real world ?

To do this you need to pick stock operating in the same segment. Example of this could be two commercial banks listed on the stock exchange, say HDFC Bank and ICICI Bank. RBI might come up with a rule that might benefit all banks and both the aforementioned banks are a part of it. One bank, say HDFC might react much sooner to it and it may become overvalued and hit second floor just like Sam. Once it gets overvalued pair traders short HDFC. Meanwhile ICICI might be slow to react just like Ram. So ICICI is undervalued, so pair trader goes long. When both banks hit the price where it is worth the amount it is actually trading at, the pair trader closes the position and books profit. This amount where the price of the stock is actually worth its trading price can be calculated by correlation of the two stocks that are involved in the trade. I’ll explain that in another post as it contains mathematics.

Moving on, some of you might be wondering about Sam’s girlfriend. Well let’s see how this data can be used. Imagine Sam attends his online classes attentively and aces his exams. This might please Sam’s mother Jane. Jane might feel that she must gift ₹500 to Sam as he cleared his exam with distinction. So she gives ₹500 to Sam. Sam might use a part of this money to buy ice cream to his girlfriend.

Let’s understand how the above paragraph works in real world. Imagine an Airplane stock, say Indigo. Indigo may come up with earnings report and say that we made X amount of profit and the number of passengers who traveled increased by Y percentage. Now this is a sign that a related industry’s stock, for example a hotel (accommodation) stock might go up too. So traders go long on the hotel stock. More fliers mean the tourism and travel industry too benefits from it. Resorts, hotels etc. are a part of it and such stock might behave just like the airline stock. Another example of it could be automobile industry. If Hyundai sells X amount of cars then a company providing some parts of the car to Hyundai too can benefit from the result. Well, I used these examples to make you understand how things work in stock market. There are a number of variables that must be taken into account before deducing expected result.

Well, do I do Pair Trading ?

If you are a long term reader of this blog then you already know the answer. I invest in competitor companies too. An example of it is Vodafone Idea and Airtel. The mistake I did was I was long on both positions. I made profit on Airtel, and Vodafone Idea collapsed. If I was short on Vodafone Idea I would have made good money. Well this happened long ago. I do experiments and make money and also blow my money and later explain the results of the experiments so that you don’t do the same mistakes. Well, that means you should subscribe to my blog so that you get to know what should be done and what should not. If you don’t like email notifications, then follow me on Twitter and Facebook. You can hit the sidebar of this website to find me on Twitter and my Facebook page is called Preetham Raghu. Before closing the tab spend some time to checkout my other posts. Well, that was it for this post, see you next time with a different post. Byeee 🙂

Disclaimer : Trading stocks is subjected to market risks. Please read all the terms and conditions before investing. The motive of this lesson was to teach little things about stocks for those who do not understand much about stocks. Candidcanblog.com will not hold any responsibility for any losses incurred to the readers of this post.

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