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PAIRS TRADING
THE FINAL FRONTIER
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Risk Disclosure
We Are Not Financial Advisors or a Broker/Dealer: Neither TheoTrade nor any of its ocers, employees,
representaAves, agents, or independent contractors are, in such capaciAes, licensed nancial advisors, registered
investment advisers, or registered broker-dealers. TheoTrade does not provide investment or nancial advice or make
investment recommendaAons, nor is it in the business of transacAng trades, nor does it direct client commodity accounts
or give commodity trading advice tailored to any parAcular clients situaAon. Nothing contained in this communicaAon
consAtutes a solicitaAon, recommendaAon, promoAon, endorsement, or oer by TheoTrade of any parAcular security,
transacAon, or investment.
SecuriAes Used as Examples: The security used in this example is used for illustraAve purposes only. TheoTrade is
not recommending that you buy or sell this security. Past performance shown in examples may not be indicaAve of future
performance.
Return on Investment ROI Examples: The security used in this example is for illustraAve purposes only. The
calculaAon used to determine the return on investment ROI does not include the number of trades, commissions, or any
other factors used to determine ROI. The ROI calculaAon measures the protability of investment and, as such, there are
alternate methods to calculate/express it. All informaAon provided are for educaAonal purposes only and does not imply,
express, or guarantee future returns. Past performance shown in examples may not be indicaAve of future performance.
InvesAng Risk: Trading securiAes can involve high risk and the loss of any funds invested. Investment informaAon
provided may not be appropriate for all investors and is provided without respect to individual investor nancial
sophisAcaAon, nancial situaAon, invesAng Ame horizon, or risk tolerance.
OpAons Trading Risk: OpAons trading is generally more complex than stock trading and may not be suitable for some
investors. GranAng opAons and some other opAons strategies can result in the loss of more than the original amount
invested. Before trading opAons, a person should review the document CharacterisAcs and Risks of Standardized OpAons,
available from your broker or any exchange on which opAons are traded.
No part of this presentaAon may be copied, recorded, or rebroadcast in any form without the prior wriXen consent
of TheoTrade .
No SoliciAng. No Recording. No Photography.
Don Kaufman
Co-Founder TheoTrade
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Learning Objectives
Introduction to Pairs Trading
Discover and Build Correlation Charts and Trades
Learn Entry and Exit Criteria for Pairs Trades
Aligning Pairs Trades
Executing Trades Upon Divergences and Statistical
Opportunities
High Probability Split Irons
Converting Pairs Trades for Options and Futures Execution
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How would this have played out over the past 5 years?
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You are looking to create one LONG position and one SHORT
position
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Pairs Logic
The Pairs logic is to seek out correlated stocks, indices, or
products currently displaying a divergence.
You are looking to create one LONG position and one SHORT
position, the PAIR offsets risk in one another.
Divergences Exist
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Pairs trading is about how to covert and trade one product versus
another and we will detail precisely how to associate the shares
of 2 products.
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If the proverbial hits the fan you better make sure your
correlation holds up. Just take a look back at 2008 and see how
a Pairs Trade may have played out. If you follow our steps your
risk will be relatively controlled in these trades.
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With heavier volatility you need LESS capital however, you will
have more exposure to risk due to Pairs decoupling.
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You might understand the general idea or gist of the Pairs trade
but now lets go through a number of specifics in order for you to
be confident in finding your own candidates.
Please do not freak out, we will walk through EVERY step multiple
times and stop along the way to provide infinite detail.
Comparison Chart
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Understanding Correlation
Correlation is the statistical measure of how two securities
move in relation to each other.
Correlation is computed into what is known as the correlation
coefficient, which ranges between -1 and +1.
There are positive correlations and negative correlations.
NEGATIVE correlation indicates a security is moving in precisely the
opposite of the primary products.
POSITIVE correlation indicates a security if moving in the same
direction or in tandem with the primary product.
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Correlation Coefficient
Look for heavy correlations in some instances EXCEEDING
80%
Correlation Consistency
Again you are seeking correlations over 80%.
Visual Divergence?
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For example, you intend to trade a Pair with a trade time horizon of 3 months.
Check 3 month, 6 month, and 9 month charts of the Comparison Pair with the
correlation study in order to substantiate your trade will stay correlated over
time.
Pairs look VERY different given a change in time frame, examine your Pair.
If trading for shorter duration use similar methodology, 3 weeks, 6 weeks, and
9 weeks, etc.
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XLE - XOM
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Standard Deviation
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Mean Reversion
Statically speaking you are looking for MEAN REVERSION
Technical analysis will NOT help you here.
Some securities move in relative tandem.
You are going to plot 2 securities and view opportunities
whereby divergence of a PAIR exist.
The Spread between 2 heavily correlated securities is mean
reverting.
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7. Historical Volatility
Historical volatility is defined as the annualized standard
deviation of the past stock price movement.
In other words its how much the stock is actually moving.
Most standard charting packages offer Historical Volatility
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Take 13.38(1.2) = 16
Execution Risk
Pairs trades are placed in 2 separate markets, stock vs stock,
options vs option, futures vs futures or any combination
thereof.
When placing Pairs Trades you will encounter LEGGING RISK
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Legging risks
In Pairs Trading you are placing 2 mutually exclusive orders into
separate marketplaces.
Blast ALL
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Risk controls
Risk $1 to make $1 is equivalent to risk $1000 to make
$1000.
Sell the product you bought and buy the product you sold.
For example the XLF is the SPDR Financial Sector ETF. You
could trade the XLF against one of the major financial
securities.
What's not to like? Take the Pairs idea and criteria apply it to
Defined Risk options spreads.
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Trade Design:
Selling an out of the money call spread in the strong product.
Selling an out of the money put spread in a separate but
correlated weaker product.
Learning Objectives
Introduction to Pairs Trading
Discover and Build Correlation Charts and Trades
Learn Entry and Exit Criteria for Pairs Trades
Aligning Pairs Trades
Executing Trades Upon Divergences and Statistical
Opportunities
High Probability Split Irons
Converting Pairs Trades for Options and Futures Execution