Pair Trading Opportunity. Analyse pair trades in Nse and bse FnO stocks

Pair Trading Opportunity

Spotting pair trade opportunity is now so easy with Equityfriend Pair Trade analysis tool. You can identify best pairs and monitor the pair price movement to spot meaningful deviation from the mean. Just select the stock pairs in the dropdown below and click on Pair Trade Analysis button. Data is updated every End of Day and all the data can be independently verified from Nse India Website.




What is pair Trading?

Pair Trading is a direct way to profit from relative performance of two stocks by simply predicting which of the two will perform better in short term. It is based on the principal of Statistical Arbitrage The best part of Pair Trading is – “you do not need to worry about the stock price direction which may go either up or down”. If you choose the pairs smartly, you can benefit in both up trending and down trending market as what matters is the relative performance of the stock pair and not the direction of movement.

Key benefits of Pair Trading

  • Market Neutral - Pair trading is Market Neutral, meaning that you can make money in both up trending and down trending market.
  • Low Risk - As Pair Trading is based on Statistical Arbitrage principal, there is an inherent floor for the maximum loss you might make. Generally speaking the losses will not break your back and you can always bounce back. 
  • Liquid and Flexible - Pair Trading gives you complete flexibility and is highly liquid i.e. you can enter or exit your position at any time to book profit or cut the losses.

Key concerns of Pair Trading

  • Maximum profit is caped – Similar to the maximum losses, the maximum profit is also caped in this strategy. The bottom line is single pair trade (of course with reasonable lot size) cannot make you extremely rich or extremely poor, however a series of pair trades can.
  • High transaction cost - As pair trades normally involve 4 transactions (2 while opening the position and 2 while booking profit or cutting losses) to complete, it’s relatively expensive when we talk about brokerage and other transaction fees. However, high costs should not be a deterrent as nothing comes for free and here we are talking about profit.

Basic steps for successful Pair Trading

Pair Trading is basically a 3 step process:

  1. Identify two stocks which move similarly – A relative comparison of stock price movement over at least one year can give you a fair idea about co-integrated price movement. By co-integrated price movement we mean that the difference of stock price remains constant over a period of time and the deviation in stock price difference is mean-reverting. You guessed it right – The pair trade opportunity arises when there is a significant deviation in stock price differential from the mean. To know more about co-integrated stock pairs please go here.
  2. Monitor the stock price movement – You have to basically look for significant deviation in difference of price of the stock pair identified in step 1 from mean difference. Confused? Don’t worry. Things will be clear while you go through the example below.
  3. Execute the trade – Once you have spotted a significant short term deviation from mean price differential, you have to Sell high priced stock and Buy low priced stock.

How to use the Equityfriend Pair Trading tool to identify profitable pair trades?

Our pair trading tool enables you to identify, monitor and spot profitable pair trading opportunities with great ease. Let’s see how:

Step 1 – Identifying the best Stock Pairs

The first step in designing your pair trade is identifying stock pairs that are highly co-integrated i.e. move together. The thumb rule is – Look for stocks from the same sector, having similar business model and comparable market cap as they have the highest chance to be co-integrated over a longer time horizon. We will take TATAMOTORS and TATAMTRDVR as an example to understand the selection process better. Based on common sense, we can be fairly accurate in assuming that they can be an ideal example of co-integrated pair. Why? Because they have the same company as underlying i.e. Tata Motors. However, we will establish this fact using our tool. Till we validate this, forget that they are co-integrated pair. So choose these companies from the drop down as shown in picture below.

pair-trade-stock-selection-process

Click on Pair Trade Analysis button and you will get the following charts. Let’s call them Chart 1 and Chart 2 for simplicity.

Chart 1 – TATAMOTORS and TATAMTRDVR price comparison chart

pair-price-comparison

Chart 2 - TATAMOTORS and TATAMTRDVR stock price difference and stock price difference mean chart

pair-price-difference-standard-deviation

Let’s focus on Chart 1 first which is a visual representation of TATAMOTORS and TATAMTRDVR price comparison over last one year. By looking at the chart, we can very well establish the fact that there is a relationship between the two stock prices. Whenever price of first goes up, price of second follows and vice versa. However, the key point to note here is – The gap between the two stocks prices (Stock Price 1 – Stock Price 2) keeps on fluctuating in short term. Sometimes it increases and sometimes it decreases (seems like the stock price difference is mean reverting). Now to establish the fact that stock price difference is mean reverting (i.e. stock pair price is co-integrated), we need to focus on Chart 2 – which is a plot of Percentage Stock Price Difference (blue line) calculated as ((Price A - Price B)*100/Price B) and Mean of Percentage Stock Price Difference (the red line – value 42.97 ). As we can see in chart that the blue line (the price difference line) has a tendency to kiss the red line (mean line) and has crossed it multiple number of times in last one year. This proves that stock price difference is mean reverting and hence they are co-integrated.

Note* - While establishing mean reversion, it's mandatory that two line cross each other multiple times in a given timeframe. Be careful about the word “multiple”.
 

So post this analysis, we can now be fairly sure that we have chosen the right pair which is co-integrated and its price difference is mean reverting.

Step 2 – Monitoring and spotting profitable pair trading opportunity

As we have now identified our target pair, it’s time to focus on spotting the real pair trade opportunity. In order to establish whether a pair trade opportunity exists or not, it is necessary to analyse the mean and standard deviation data that appears at the bottom of Chart 2, which for our case is:

pair-sd

Let’s find out the meaning of individual values one by one.

  • Mean – Here the Mean of % stock price difference is 42.97 (first box above – same as red line in Chart 2). Generally speaking this means, on an average TATAMOTORS trades at 43% higher rate than TATAMTRDVR.
  • Standard Deviation – The value of standard deviation of % stock price difference is 8.73 (Second box above). Generally speaking this means, the stock price of TATAMOTORS trades in the range of 51.7% (42.97+8.73) to 36.24% (42.97-8.73) above TATAMTRDVR price.
  • Maximum Deviation From Mean – The value is 24.33, which means TATAMOTORS has traded at maximum premium of 67.3% (42.97+24.33) to TATAMTRDVR in past one year. It is the highest point on blue line in Chart 2
  • Minimum Deviation From Mean – The value is -18.03, which means TATAMOTORS has traded at minimum premium of 24.94% (42.97-18.03) to TATAMTRDVR in last one year. This is the lowest point on blue line in Chart 2.
  • Current Deviation From Mean – The value is 13.28, which means TATAMOTORS is currently (02-Sep-2016) trading at a premium of 56.25% (42.97+13.28) to TATAMTRDVR. This is the last point on blue line in Chart 2.

The Secret Sauce – The best profitable pair trade opportunity arises where the Current Deviation From Mean is either near Maximum Deviation From Mean or Minimum Deviation From Mean. In other words, Current Deviation From Mean should be significantly larger or smaller than Standard Deviation. How large or small depends on your risk appetite.

In our case, the current deviation is 13.28, while the standard deviation is 8.73. If we talk about our risk appetite, we are not too comfortable with the trade at this point of time. We would rather wait for current deviation to drift more towards max deviation i.e. 24.94. May be a value in the range of 18 to 20 will make us more confident. Having said that, you are free to choose your own deviation level, which will primarily depend on how much risk you can bear.

Step 3 - Which stock to buy and which one to sell in the Pair Trade Strategy?

In general, the stock having larger relative price gain will shed the gain and stock with lower relative price gain with absorb more gain in coming trading sessions. To identify the relative gains or losses, zoom in on Chart 1 (The Price Comparison Chart). To zoom in you need to press and hold left click + drag on Chart 1. Zoom in results in following view for our case:

pair-relative-performance

To gauge the relative outperformance or underperformance, focus on what has happened in last few trading session. In this case, TATAMOTORS is the relative outperformer since the price rise in last few days for TATAMOTORS has been quite steep as compared to TATAMTRDVR. Why? The slope of TATAMOTORS price chart is steeper as compared to TATAMTRDVR.

The Secret Sauce – Sell the relative outperformer and Buy the relative underperformer.

So for this case, short TATAMOTORS and buy TATAMTRDVR.

As now you know how to use our Pair Trading tool. Enjoy playing around with different pair of stock to find your ideal pairs.

Word of Caution: Example of TATAMOTORS and TATAMTRDVR discussed above is just to show how our tool functions and how you can use it to identify target pairs. This analysis is in no way a recommendation for pair trading in these stocks and we are in no way responsible for the profit or losses you make through your investment decisions using this tool. 


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