If you’ve ever travelled on an interstate, chances are you would have seen the main highway with vehicles buzzing along it. Alongside this, there is generally a single road known as the service road, which provides access to driveways, shops, homes and businesses. The local-express lanes may also be referred to as such. This road runs alongside the main highway for its entire length.
Envision a newly constructed highway and service road. The contractor tasked with their construction comes across a small tree at one point and decides to take a slight detour around it instead of cutting it down – continuing along the highway afterwards.
This road has been constructed and it’s now being used. What are your thoughts on this?
The two roads share the same alignment all along the length. Whenever the highway is bent to its left or right side, so is the service road. Similarly, when it encounters a river, both roads take that into consideration as well. Thus both roads ‘act’ very much in tandem with one another, except for where a tree temporarily blocked the service road.
Let’s take this a step further and break it down into variables –
Entities – Highway and the service road
Relationship – The two entities are defined by their parallelity. What happens to one entity (highway) is likely to happen to the other (service road)
Relationship anomaly – In an otherwise perfect world, the tree on the service road causes a brief break in the parallelity of the two roads
Effect of the anomaly – The anomaly is short-lived, the roads are quick to regain their relationship
This may seem like an odd comparison, yet if you can envision the highway, service road and tree in parallel, and comprehend their relationship, then you should (hopefully) grasp the underlying philosophy of pair trading.
Let me try and accomplish this goal.
Just like the highway and service road, two similar entities can be compared with HDFC Bank and ICICI Bank.
If you purchase any authoritative books about Pair Trading, for instance, you probably will come across an example of Coca-Cola and Pepsi. Since those are not accessible on the Indian market, we can use ICICI and HDFC instead.
Both of these banks are incredibly alike in all areas.
HDFC and ICICI are both banks in the private sector.
Both have similar banking products
Both cater to similar client base
They both have a strong presence in the nation.
Both banks are subject to the same regulations. The constraints imposed on both financial institutions are similar.
The two banks experience similar difficulties in managing the operation of their respective enterprises.
And so on.
The striking parallels between these two banks mean that any alteration to the commercial landscape will have an equivalent impact on both. For instance, if the Reserve Bank of India bumps up interest rates, then it will affect both institutions; similarly, when these rates are reduced.
At this moment, we can establish –
HDFC and ICICI are two entities.
The relationship – similar business landscape
Given the above inference, we can make the following conclusion –
Because both the business are so alike, their stock price movement should be similar
On any given day, it is anticipated that if HDFC Bank’s stock price rises, ICICI Bank’s stock price will follow suit.
HDFC’s stock price is likely to have an effect on ICICI’s stock price, with a decrease in the former prompting a decrease in the latter.
We can make a generalisation here
Considering their well-established relationship, one could expect entity 2’s stock price to follow the same direction as that of entity 1’s when all else is equal. In other words, if not, this may present a trading opportunity.
For instance, one may conclude that ICICI stock has gone up higher than anticipated judging from HDFC’s performance, given its usual correlation: if ICICI is up X%, HDFC should have increased by at least y%. However, instead of rising, HDFC remained flat.
In the arbitrage world, one would buy HDFC stock which is cheaper and sell ICICI stock which is more expensive.
Essentially, ‘Pair Trading’ is what this is all about.
Wait a second – what was the point of the tree on the service road? Keep in mind it caused an anomaly in the otherwise parallel relationship between both roads.
In an otherwise ideal relationship between two companies’ stock prices, the occurrence of an event can lead to a price discrepancy, where one stock might fluctuate from the other.
Anomaly in stock prices presents us with a great chance to trade. This can be due to numerous reasons.
HDFC Bank recently released their quarterly results, which had a greater effect on the stock price of HDFC than on ICICI. This, in turn, slightly altered the usual relationship between the two stocks; however, it will soon be restored to its usual state.
In a similar vein, ICICI has released its results.
When a top executive at one of the banks resigns, it causes a slight dip in its stock price, though the other continues to be traded regularly.
Excessive speculation in stock 1 compared to stocks 2
Generally speaking, a price anomaly is an event that causes one stock to react or overreact in comparison to another. As this only impacts one of the two stocks in our universe, I prefer to refer to it as a local event.
The connection between the two stocks sets the parameters for pair trading. Thus, the bulk of the effort lies in –
Identifying the relationship between two stocks
Quantifying their relationship
Tracking the behaviour of this relationship on a dai
Looking for anomalies in the price behaviour.
There are lots of approaches used to analyse the connections between two stocks. Two of the most common methods are based on…
Price spreads and ratios
These two techniques vary significantly and are quite intricate. I am hoping to cover them both in my Varsity lecture.
As we wrap up this chapter, let’s reflect on the history of Pair trading.
Gerry Bamberger from Morgan Stanley is credited for pioneering pair trades in the early 80’s. This trading technique was kept ‘proprietary’ by Gerry until Nunzio Tartaglia, another trader from Morgan Stanley, popularised it.
Nunzio had a massive following then; he was one of the first to experiment with ‘Quant trading’, leading Morgan Stanley’s prop trading desk in the 80’s.
DE Shaw, the renowned Hedge Fund, implemented this strategy during its early days.
– Few closing thoughts
As you have likely deduced, pair trading necessitates the purchase and sale of two separate stocks or assets/indices. People familiar with this strategy tend to believe it is a market neutral technique, since one is long and short simultaneously. However, this notion is erroneous as one would be investing in two distinct assets.
To be market neutral, you could take a position in a calendar spread. This involves having both long and short positions on the same underlying expiring at different dates.
Therefore, do not assume that pair trading is market neutral. Rather, it is an approach which attempts to capitalise on the discrepancies between two linked assets.
By simultaneously buying and selling two assets, we are aiming to benefit from the discrepancy of their respective value. Therefore, I suggest calling Pair trading ‘Relative Value trading’.
Considering this, it is clear that this is an arbitrage opportunity – we buy the undervalued security and sell the overvalued one. This strategy can also be known as Statistical Arbitrage.
We will begin to explore the process of determining whether something is ‘undervalued’ or ‘overvalued’ relative to each other in the upcoming chapter.