2.1 - The Objectives

You would notice that interstate highways usually include the main highway. This is where the cars zoom past at top speed. It is not uncommon to see a single road on either side of an interstate highway. This road is sometimes called the service road. This road allows private driveways, shops and houses to access the service road. These service roads are also called the local-express lanes. For the whole length of the highway, the service road and highway run usually parallel to one another.

Imagine this: A new highway and service road are being built. The highway contractor has stated that the highway and the service road will be laid. The contractor comes across a tiny tree while laying the new service road. The road contractor, however, decides to not cut the tree, but to circumvent it by making a slight deviation from the tree, and then getting back on track to run parallel with the highway.

This is how the road is built and then people use it. How do you interpret it?

The two roads run parallel for the entire stretch, if you think about it. If the highway is inclined at any point, the service road will follow suit. The service road would also be affected if the highway went down. The service road would also be affected if the highway crosses a river. And so on. The two roads behave almost identically for practical purposes. Except at the point when the tree temporarily blocked the path on the service side road.

Let's go one step further. Let's break it down into variables.

1. Entities - Highways and service roads
2. Relationship - Two entities are defined by the degree of their parallelity. What happens to one entity (highway), is likely to happen at the other (service highway).
3. Relationship anomaly – In an otherwise perfect world the tree on the service roads causes a short break in the parallelity between the two roads
4. Effect of the anomaly: The anomaly is temporary, and the roads quickly regain their relationship

This is a strange analogy. But if you can imagine the highway, the service road and the tree and the parallel relationships between them, you will be able to understand the core philosophy behind pair trading.

Let me try to do this.

Just like the roads or entities, i.e. the highway and the service road, think of two similar companies, let's take HDFC Bank (or ICICI Bank).

You will also find the examples of Coca-Cola or Pepsi in any book on Pair Trading. Let's move on to HDFC and ICICI, as they aren't listed in India.

1. These two banks are very similar in all respects
2. Both banks are private sector.
3. Both offer similar banking products
4. Both serve a similar client base
5. Both are present in the country in similar ways
6. Both banks are subject to similar regulatory restrictions
7. Both banks face similar challenges when it comes to running their business

And so on.

Due to the striking similarities between these two banks, any change in the business environment should affect the 2 and 3 banks in the same manner. If RBI raises interest rates, both banks will be affected in the same manner.

We can now define -

1. The entities - HDFC & ICICI
2. The relationship - similar business landscape

Conclusion from the following -

1. Both the business and stock prices should move in a similar way because they are so similar
2. If the stock price of HDFC Bank goes up, then ICICI Bank's price will also go up.
3. If the HDFC stock price falls, then ICICI stock price will also fall

This can be summed up as:

Because of the established relationship between the companies, entity 1's stock price is expected to move in the same direction as entity 2. If not, there may be a trading opportunity.

If ICICI stock prices rise by X% on a given day, then HDFC's stock price is expected to rise at least y%. However, let us assume that HDFC remained flat. We can then claim that ICICI stock has moved higher than we expected compared to HDFC stock price.

Arbitrage is the act of buying the cheapest stock, i.e HDFC, and selling the more expensive stock, i.e ICICI.

This is the core and purpose for "Pair Trading".

Wait a minute - what about that tree on the service road? And its significance to the entire narration? You may recall the tree that caused an anomaly within the otherwise perfect "parallel” relationship between the roads.

In a similar fashion, even if the stock prices of both companies are in a perfect relationship, an event could cause a price anomaly. Stock 1's price can differ from stock 2's.

A stock price anomaly gives us the opportunity to trade. An anomaly could be caused by anything.

1. HDFC Bank announces quarterly results - this has an immediate impact on HDFC more than ICICI. Therefore, the price relationship between these changes and HDFC will need to be rebalanced later.
2. Similar with ICICI's announcement of its results
3. One of these banks' top executives resigns, which causes a slight drop in the stock price. However, the other bank continues to trade regularly.
4. Stock 1 is more speculation than stocks 2.

A price anomaly, as it is commonly known, is an event that causes the stock prices of one company to react (or overreact) differently than the other. It is a local event, as it only affects one company out of our two stocks.

The relationship is what sets the rules for how the stock prices relate. The bulk of pair trading is therefore based on -

1. Recognizing the relationship between two stocks
2. Quantifying their relationship
3. Monitoring the behavior of this relationship daily
4. Look out for price anomalies.

These relationships can be defined in many ways between stocks. These two techniques are popular because they use-

1. Ratios and price spreads
2. Linear Regression

These techniques are very different. Both of these techniques will be discussed in Varsity.

A quick overview of the history and development of Pair trading before we close this chapter.

Morgan Stanley executed the first pair trade in the 80's, by Gerry Bamberger, a trader. Gerry, a trader named Gerry Bamberger, was the one who discovered the technique. He kept it secret for many years until Nunzio Tartaglia (again from Morgan Stanley) popularized it.

Nunzio was a pioneer in Wall Street's 'Quant trading' and enjoyed a large following at the time. He was actually the head of Morgan Stanley's prop trading desk during the 1980's.

This strategy was adopted by DE Shaw, the famous Hedge Fund.

2.2 -Few Closing considerations

Pair trading, as you might have guessed requires you to simultaneously buy and sell two stocks/assets/indices. Pair trading is considered a neutral strategy by many. Because you can trade both long and short simultaneously, it is market neutral. This is grossly incorrect, as you are both long and short in two stocks.

Market neutrality means that you can be both long and short on the same underlying at the same moment. The calendar spread is a good example. A calendar spread is where you can be both long and short on the same underwriting expiring at two different dates.

Please don't assume that pair trading is market neutral. This strategy seeks to profit from price differentials between related assets.

We are trying to make a profit on the "relative values" of both the assets by simultaneously selling and buying them. Pair trading is  termed as "Relative Value Trading".

This is an arbitrage opportunity in its purest sense. We buy the undervalued security, and we sell the overvalued one. This is sometimes called statistical arbitrage.

How to measure the 'undervalued’ or 'overvalued? This is always done with regard to each other. We'll be learning this measurement technique in the next chapter.

Keypoints

1. Stock prices for companies with similar business environments tend to show similar price movements
2. It is possible to quantify the price movements by
3. An anomaly in price movement can be caused by a local event (usually involving 1 company).
4. Trades are possible when an anomaly is detected
5. Pair trading is where you purchase the undervalued security, and then sell it.
6. Pair trading can also be called statistical arbitrage or relative value trading.