It’s a sixty-year-old strategy that has been well exploited over the years by hedge funds to deliver low-risk and high returns to investors. Alfred Winslow Jones, who is credited with creating the first hedge fund in 1949, is known to be have extensively used the investment style to outperform market averages. This potent trading tool, referred to as pair trading, is popular because of its market-neutral nature. Such is the strategy’s draw that Sanjiv Duggal, investment director (India) of Halbis, in an interview with Eurekahedge in 2007, remarked that half of the hedge fund’s book consists of pair trades.

So what is pair strategy all about? The market-neutral strategy, which was popularised by Gerald Bamberger and Nunzio Tartaglia of the analytical proprietary trading group at Morgan Stanley in the 1980s, involves identifying two highly correlated scrips within the same sector. Once the correlation breaks down as one stock trades higher and the other trades lower, you make a trade by selling the outperformer and buying the underperformer. The trade is initiated betting that the “spread” between the two will eventually converge, also called as mean reversion. Mean reversion strategy is based on the mathematical premise that all prices will eventually move back towards the mean or average return. Thus, if a stock is underperforming, its price will move towards its average value when the market rebounds.

“In a pair trade, you are not making a bet on the direction of the stocks in absolute terms, but on the direction of the stocks relative to each other. The probability of making profits whether market moves up or down, or remains sideways increases,” says Alok Agarwal, PMS-head and fund manager-equities at K R Choksey Shares and Securities (See chart: The power of two). Statistical arbitrage, relative value arbitrage, and long & short equity are the monikers that this strategy is known by in the reclusive world of hedge funds. But, of late, the strategy, once reserved for the privileged (read institutions), is finding its way to most cash-rich individuals.

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The power of two

The following pair shows that even in the falling market as seen in 2008, when stocks fell in tandem, investors could have made returns of 10 per cent by going long on DLF and shorting an equivalent value of JP Associates during January 14 and October 17

Source: Bloomberg

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Closer home, brokerages are offering pair strategy as part of their portfolio management services. “In a scenario of extreme volatility, pair trading can work wonders. In fact, the strategy can deliver average returns of 30-40 per cent in a year,” says Agarwal, who has successfully initiated over 100 such trades in the last one-and-a-half year. Though the indices have doubled since March, a phenomenal 100 per cent returns in seven months, a majority of investors lost out on the big move as there was excessive pessimism abounding the Street. While timing the market was always a difficult thing to do, what pair strategy brings to the table is eye popping. With a hit ratio of 85 per cent and an average gain of 5 per cent per trade, with average trading period of 10 days, one could have matched the gains if not outperform during the same period (see chart: Lucrative enough). Also what makes the outlook rosy for pair trading (read higher returns) in India is the fact there are only a handful of players who are pursuing such strategies, unlike in the West where the over $800 billion strong quant fund industry is exploiting the strategy through algorithmic trading systems.

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Lucrative enough

The following trade which entailed buying Tata Motors and selling M&M hit the bulls eye as the price ratio after hitting the target of 0.42 continued to move further to 0.70. In other words, the profi ts could have been 90 per cent instead of the booked returns of 10 per cen

Source: Bloomberg

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What’s in a pair strategy?

Pair strategies basically involve two techniques: statistical arbitrage-based convergence trades, and fundamentally-driven valuation trades. In a statistical approach, the trade is initiated based on statistical tools such as Z score, T score, standard deviation and moving averages. In developed markets, these trades are mostly executed seamlessly through automated trading systems, also known as algorithmic trading, in which computers execute orders.

The best part in pair trading is you do not have any call on the direction of the marketAlok Agarwal PMS-head and fund manager, KR Choksey

However, according to Yogesh Radke, head of quantitative research of Edelweiss securities, statistical pair trading is not a fully automated process. “80 per cent of the background work is statistics, but the rest 20 per cent is as crucial since it involves an individual’s understanding of the markets,” he adds.

Statistical pair is different than hedging or a normal arbitrage. Arbitrage is nearly a zero risk trade where investors buy in cash and sell in futures simultaneously sans any market risk. In hedging, investors go long or short depending on their view on the market and hedge it by selling or buying index futures. But statistical pairs are based on the fundamental principle of mean reversion or law of averages. This falls in between arbitrage, a zero risk, and taking directional position, which is the most risky. “The best part in pair trading is you do not have any call on the direction of the market,” says Agarwal of KRC. The relationship between a correlated pair is much more predictable than the outright direction of any given stock. In fact, studies of over 450 hedge funds have shown long/short trading to deliver the best risk-adjusted returns over other strategies. “In times of market uncertainty and volatility this style thrives and delivers consistent profits,” says Radke of Edelweiss.

The fundamental approach, usually adopted by large hedge funds, is aimed at arriving at a proper valuation for a stock. The most undervalued stock is bought, while shorting the most overvalued stock. In this case, the investor has to wait for the fundamentals to play out and the relative performance to shift.

How to initiate pair trades

According to market experts, there are five parameters for selecting a pair. First, the stock should be traded in futures and options, second, the stock should be liquid, third, the pair should be sector-neutral (stocks within the same sector), fourth, it should be business-neutral (similar business structure). Most importantly, one has to keep an eye on the moving average of the pair (for example 21-day) or to, put simply, one has to also see the historical data points and check weather it reverts back to the mean or not. Last but not the least, the minimum investment in such a trade is around Rs 5 lakh given the high contract sizes in the futures market.

In times of market uncertainty and volatility this style thrives and delivers consistent profitsYogesh Radke head of quantitative research, Edelweiss

Besides, investors need to figure out if the prices of the chosen pair are moving in tandem. For example, State Bank of India and Punjab National Bank had a correlation of above 0.90 for the past six months, making it a good candidate for pair trade. But a high correlation need not necessarily culminate into an effective pair if the variables influencing the two are not similar. For example, tur dal and the Nifty will not make a good pair even if the correlation is high.

Some traders also believe that lot sizes of both the stocks should approximately be of the same size and that the transaction should be equal in cost. More importantly, it also has to be a rupee-neutral trade. For example, for every Rs 5 lakh of long trade, you need to sell or go short for the same value. Unlike in the US where investors can sell short in the cash market by borrowing the shares through lending and borrowing mechanism, in India the only option is to execute the trade in the futures market.

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Playing it safe

The trade of PNB (buy at Rs 492) and Canara Bank (sell at Rs 205) was initiated at a price ratio of 2.40 for a target of 2.59. However, the stop-loss was triggered at a pre-defined price ratio of 2.28. Had the investor continued with his position, the losses would have increased signifi cantly as the ratio, instead of reverting back to the mean, hit a low of 1.90

Source: Bloomberg

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Inter-sector pairs are risky

If an investor had initiated a position by selling the BSE realty index and buying the BSE healthcare index, the returns would have been in excess of 50 per cent in 10 months. However, the loss would have been more if the investor had taken a wrong call by buying realty and selling healthcare. More importantly, such trades do not revert to the mean for longer durations

Source: Bloomberg

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Types of pair trading

In statistical trading, the strategy is to make profit by tracking divergences or a mean reversion trade. For example, State Bank of India and Punjab National Bank make a very good pair. Whenever the ratio deviates from the mean (21-day) it reverts back to the mean, which is also called convergence pair trading. Mean reversion is more often used while initiating the trade as we know there is high probability that the direction will be towards the mean.

In mean divergence trades, the pair is already trading at its mean, so the probability is 0.5 of going either side. Position is initiated with a view that the pair will either move upside from the mean or pierce the mean and move towards the downside. In this trade, technical analysts extensively gauge the movement of the ratio of the pair. “Mean divergence forms almost 15-20 per cent of the pair trades carried out at Edelweiss. There are other factors like fundamentals of the companies in the pair and historical pattern of the ratio of the pair which we look at before entering into such trade,” says Radke.

Fundamental-based pair strategy, which hedge funds normally employ, is aimed at identifying the out-performers and selling the under-performers on the basis of fundamental factors like price earnings or price to book value. “They form a very small percentage of our trades. Moreover, these trades are of longer durations, running into more than three months, at times. But the expected returns from the trades too are at the higher end,” adds Radke.

The long and short of it

Pair trading is a low-risk game but that does not mean it is a zero-risk game. One of the basis of pair trade is correlation of the two securities which might not hold going forward. If this happens then the pair can continue to diverge away from its mean. The tricky part of any loss-making trade is that the standard deviation of the price ratio will keep on rising, making the trade more alluring. In other words, instead of reverting to the mean, the price ratio could continue to defy the trend established in the past, resulting in a higher probability of mean reversion. But instead of giving into the temptation of increasing your exposure to the trade, it’s wiser to adhere to a strict stop-loss on a per cent or on actual rupee basis. “Usually, the risk-reward ratio should be looked at to arrive at a stop-loss. We at KRC look for pair trades where risk reward ratio is at least 1.5, any thing less than this we avoid the trade no matter how tempting it is,” says Agarwal.

According to Radke of Edelweiss, the most important trait in trading is discipline. Putting it in perspective, Radke says, “On January 7th, we had initiated a pair trade between PNB and Canara Bank (Sell PNB and Buy Canara Bank) at a price ratio of 2.40 for a target of 2.59 and a stop loss of 2.28. After holding it till the 14th, the stop-loss got hit at 2.28 and we closed the trade at a loss of 6 per cent. It does not feel good but it is a part of the game. The ratio went to as low as 1.90 in the next 30 trading sessions. Had we stuck to the position we would have incurred a loss of 16 per cent.” (See chart: Playing it safe)

But there are traders who believe there is a way of exiting a loss-making trade. “More often than not I have seen that a pair starts trading in the way it should have had after nearing the stop-loss limit. At this point I look at technical indicators of the ratio such as the relative strength index and decide when to get out of the position,” says a trader with a quant fund on the condition of anonymity.

The other risk comes through inter-sector pairs such as pharma and realty. The basic principle of pair trade is being market neutral, but in an inter-sector pair trade, the trader is actually betting on two directional calls which is risky. Though the risks are high, the payoffs are tempting too. For example, if one would have bought BSE Health Care index in December 2007 and sold BSE Realty index at then prevailing ratio of 0.31 (throughout the month it was 0.31), in a year’s time an investor would have made a killing by multiplying his investment six times. (See chart: Inter-sector pairs are risky). However, Agarwal, feels the risk in not worth it. “On the face of it inter-sector trades are more profitable, but statistically it is proved that they do not have a strong correlation. Even if you put stop-losses, you do not have a mechanism of exiting such trades,” points out Agarwal.

But despite the inherent risks, pair trading is viewed as an investment strategy that eliminates the risk of taking directional bets. “One who wants a reasonable return in the range of 25-30 per cent (year on year) is an ideal candidate for such trades,” says Agarwal. Hence, investors looking at that extra bit of stability in their portfolio along with some mouth-watering returns, pair strategy could well fit like a T.