Pairs Trading: How to Trade Pairs

Traders have hundreds of technical tools and price action strategies to help them take advantage of price trends and ranging markets, but pairs trading is something completely different. Pairs trading uses correlations and divergences between two stocks in an attempt to capture a profit. While it isn’t riskless, by understanding how pairs trading works, how you control risk and how you manage profits, it’s a great tool to add to your trading arsenal because the strategy isn’t dependant on market direction.

Pairs Trading 101

Pairs trading is when a simultaneous long position is taken in one stock while a short position is taken in another.

The stocks must be highly correlated, meaning most of the time they move in the same direction. Typically, this is seen in the stocks of companies that are very similar, such as Coca-Cola Bottling Co. (KO) and Pepsico Inc. (PEP), or Ford (F) and General Motors (GM).

Since the stocks of these companies move in a similar fashion due to their similar business—we always must check to make sure they are moving in a similar fashion—when their stocks diverge it presents a trading opportunity. The strategy is to buy the stock that is underperforming and short-sell the one that is outperforming the other. Doing this safely requires some research and risk controls.

See also 25 Stocks Day Traders Love

Pairs Trading Considerations

Before utilizing this strategy we first must see if two stocks are correlated. We want them to move in tandem most of the time; that way, when they diverge from one another, if history holds true, then eventually they will revert back to trading in tandem and a profit can be made.

F (red) and GM (green) Comparison Daily Chart
Figure 1. F (red) and GM (green) Comparison Daily Chart (Percentage Scale) – Source: Freestockcharts.com

Figure 1 shows that over this time frame, Ford and General Motors often move in tandem. When they separated it presented an opportunity to short-sell GM when it was outperforming, and buy Ford when it was underperforming. As long as the stocks eventually come back to trading in tandem then a profit is made. In this case they did.

Overall market direction doesn’t matter. As long as the stocks separate and then come back together a profit is made, even if both stocks drop or both rally but get back in sync by doing it.

That’s the theory, but deciding when to take a pairs trade, how to control risk, and when to take profit is a more precise matter.

Stockcharts.com allows you to plot a chart that shows the ratio of one stock compared to another. Figure 2 shows the share price of Ford divided by the share price of General Motors. The ratio is currently 0.51, meaning Ford is almost exactly half the price of GM.

See also Trend Reversals: How to Spot and How to Trade

F / GM Share Price with 200-day Moving Average
Figure 2. F / GM Share Price with 200-day Moving Average and 200 Day Bollinger Bands (2.5 Standard Deviations) – Source: StockCharts.com

A 200-day period moving average is applied to get a “normal” ratio (currently 0.45). Bollinger Bands are also applied (200 periods and 2.5 standard deviations) to spot times when the ratio has moved significantly away from the norm, offering a trading opportunity.

The next section shows how to pick an entry and get out, but before that, position sizing must be addressed. The stocks are priced differently; according to current data General Motors is about twice as much as Ford. This means we can’t buy the same number of shares in each, we must calibrate each position.

Be sure to also read Don’t Fred, Salvage Your Losing Position with Options

The easiest way to determine position size is to set a fixed dollar amount for each side of the trade, say $10,000. Buy $10,000 worth of one stock and sell $10,000 worth of the other stock. That way the exposure is the same, but the number of shares held in each will be different.

Pairs Trading Example Explained

Consider the trade that occurred in December 2013. Ford declined steeply in value relative to GM, as is shown in both figures 1 and 2.

On December 6, the ratio breaks below 2.5 standard deviations (lower red Bollinger Bands) from the 200-day norm. Ford is falling and GM is rallying; the stocks are diverging. While a trade can be taken at the exact moment the ratio penetrates the 2.5 standard deviation Bollinger Band, it is prudent to wait for both the stock prices and the ratio to start converging (moving back toward normal) again before taking the trade.

See also Analyzing Trading Volume: The Ultimate Guide

In this case, we don’t see the ratio begin to trend back higher until January 2. By waiting for the ratio to begin heading back toward the norm we avoid holding a losing position for longer than we need to (in this case it would have been almost a month), and we can also place a stop below the recent low in our long trade and above the recent high in our short trade.

Therefore, enter trades when the ratio has gone beyond 2.5 standard deviations from the 200-day norm and is starting to move back toward the norm. Exit when the ratio comes within 0.02 points of 200-day norm.

This is how the trade looks on the ratio chart.

F / GM Ratio Pairs Trade Entry and Exit
Figure 3. F / GM Ratio Pairs Trade Entry and Exit – Source: StockCharts.com

Buy Ford near the close on January 2 at $15.44. Place a stop loss below the recent low at $15.10.

Short-sell GM near the close on January 2 at $40.95. Place a stop above the recent high at $41.85.

Pairs Trade with Entries, Stops and Exit
Figure 4. Pairs Trade with Entries, Stops and Exit – Source: FreeStockCharts.com

If each side of the trade is allocated $10,000, then we buy 647 shares of Ford ($10,000 / $15.44) and sell 244 shares of General Motors ($10,000 / $40.95).

Close out trade near the market close on January 24 because the ratio has moved to within 0.02 of the norm (200-day average). Therefore, we can conclude the price relationship has reestablished itself and our reason for entering the trade has now diminished.

GM is closed at $36.83 and Ford at $15.83.

Profit collected is:

General Motors: $40.95 – $36.83 = $4.12 × 244 shares = $1,005.28

Ford: $15.83 – $15.44 = 0.39 × 647 = $252.33

Net Profit: $1,005.28 + $252.33 = $1,257.61

The short trade creates a cash inflow that offsets the outflow of the long position, so there is minimal cash outlay. If calculating the return based on the initial $20,000 in positions though, the return is greater than 6% in less than a month.

Not all pairs trades will work out this well; sometimes only one trade will be profitable and the other a loser, other times both trades may be unprofitable.

The stop losses also contained risk to a small amount of capital, and the profit potential was much greater than the risk with these stops in place.

If either position gets stopped out, exit the other trade as well. With this style of pairs trading you always have two positions or no positions.

Pros and Cons of Pairs Trading

Pros include the strategy being market neutral. Just address the dynamic that is going on between the stocks and little regard or time needs to be committed to study of broader market conditions. The strategy is also quite flexible; shorter term traders can use less of a standard deviation or a shorter time frame (i.e. 30-minute chart) to trigger more trade signals.

Cons include the possibility that a divergence can last much longer than expected, or the prices can simply continue to diverge based on fundamental changes in company structure or performance. This is why a risk limit must be set to avoid catastrophe situations where the two stocks continue to move more and more out of sync. The strategy also goes against traditional trend trading concepts of buying the strongest stocks and selling the weakest – pairs trading does the opposite.

This strategy is also subjective. The price must diverge, and then we wait to take the trades until the prices start to converge again. While this is theoretically a safer approach, it takes skill and practice to develop that timing.

Traders must also consider a stock’s beta. Two similar stocks that have very different betas indicate a discrepancy in volatility. If one stock is much more volatile than the other it could cause issues with the trade. Ideally, pairs trade with stocks that are correlated and have similar betas.

The Bottom Line

Pairs trading involves taking a long and short trade simultaneously in two typically highly correlated stocks with similar volatility. A long position is taken when one stock underperforms by a certain threshold, and a short trade is taken in the outperformer, with the intent that the stocks will eventually revert to the historical norm thus resulting in a profit. If the stocks do revert to being highly correlated, the trade is profitable, but risk controls in the form of stops should be used to avoid situations where stocks continue to diverge. Reversions to the norm can take a long time, so traders must weigh which trades are worth the potential wait and risk, and which aren’t.

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The doji candlestick pattern is a cross-, plus- or T-like pattern that indicates indecision in the market. Traders can use the pattern on its own or in combination with other candlestick patterns to identify potential reversals in the prevailing trend.

Doji candlestick patterns

Doji candlestick patterns are very simple to recognize:

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The very thin real body suggests that there’s a lot of directional indecision in the market – that is, bulls and bears are fighting over control. Longer shadows usually indicate a larger fight with a lot of volatility, while shorter shadows suggest a quieter market with little volatility. Doji patterns with long shadows are usually the most reliable trading signals.

How to Trade Doji Patterns

Doji patterns are interpreted by varying positions and length of shadows, so traders have given different names to different shadow arrangements.

The most popular doji patterns include:

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  • Gravestone Doji: Gravestone doji appear like an inverse letter “T” and is most reliable when it appears after a significant uptrend. After opening higher, bulls lose control over the price and bears take over throughout the session.

When trading in these patterns, it’s important to take the previous trend and volume into consideration. The most reliable trading signals are generated following a strong previous trend with higher than average volume during the doji session. It’s also a good idea to consider other forms of technical analysis as confirmation, such as trend line support or resistance levels.

Examples of Doji Patterns in Action

Let’s take a look at an example of a dragonfly doji in the SPDR S&P 500 ETF (SPY).

Doji candlestick in action
Source: TradingView

In the above chart, the dragonfly doji is immediately followed by a sharp increase in price as the bulls take over control of the price from the bears. The strong volume just before and on the doji pattern provides a strong signal that a directional move is about to occur. When zooming in, the breakout also occurs from a key trend line resistance level, which further confirms that a bullish move higher is likely to occur.

The Bottom Line

Doji candlestick patterns indicate indecision in the market. Depending on the length of the shadow and other factors, the indecision can translate to an imminent reversal in price or a mere suggestion that a reversal will eventually occur. The key is to look at the prior trend and volume for context, as well as using doji candlestick patterns in conjunction with other forms of technical analysis that can serve as confirmation.

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