Theoretical review on The Pairs Trading

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Theoretical review on The Pairs Trading

Introduction

Pair trading refers to a strategy of matching a short position with a long position in two stocks that comes from the same sector. This enables the investor to gain virtually in all market conditions, that is, sideways, downtrend or uptrend movements. (Gatev, Goetzmann & Rouwenhorst, 2006).  Taking a long position in one security  combined with a short position in another stock that belongs to the same sector creates a hedge against overall market and sector in which the stock are based. In essence, the hedge created is a bet that is placed on the two stocks, that is, the long position stock and the Short position stock (Perlin, 2009). Pair trading is characterized by Convergence trade. Convergence trade refers to a trading strategy that is made up of two positions, (buying one asset forward and selling on of the similar asset forward for  higher price, expecting that when assets have to be delivered the two prices will have converged (came closer to equal) and thus make a profit) (Hong & Susmel, 2003).

On addition to this. Pair trading is considered to be a Statistical arbitrage strategy (Elliott, et al., 2005). In statistical arbitrage, there exist a statistical mispricing of an asset or many assets based on these assets’ expected value. This means that the term statistical arbitrage conjectures the existence of statistical mispricing of the price relationships which are true in expectations. Pair trading monitors the performance of the two securities that are historically related (Perlin, 2009). The weakening in the correlation that exists between the two securities, the pair’s trade would be to long the underperforming stock and short the outperforming one, having an expectation that the spread between the two stocks will converge (Nath, 2003). The two stocks divergence can be caused by temporary demand and supply changes (that is, large sell and buy orders) of the security, or investors’ reaction to the news about one of the companies. For example, if one company announces a high interim profit or dividend, it can result in high demand for its share.

Implementing a pairs trading strategy requires market timing, good opposition sizing and high decision-making skill (Perlin, 2009). The strategy is crippled by lack of or scarce opportunities given that in order to profit, the investor has to be one of the first few investors to capitalize on the open opportunity before others join. Pairs trading were pioneered by a team of mathematicians, computer scientists, and physicists that were brought together by the Morgan Stanley & Co, and the team included Gerry Bamberger and Nunzio Tartaglia. they came together to study the existing arbitrage opportunities in the stock market by the use of advanced statistical and modeling and coming up an automated