V. 19:3 (19-26): Pairs Trading by Stephane Reverre

V. 19:3 (19-26): Pairs Trading by Stephane Reverre
Item# \V19\C03\026PAIR.PDF
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Exploiting Closely Related Stocks Pairs Trading

Some relationships in the stock market make for very profitable trades. by Stephane Reverre

The arbitrage of Royal Dutch (RD) and Shell (SC) is a popular one on Wall Street because it is a classic example of a pair-tradingÝ model, a strategy that involves trading two stocks — one long, the other short-term based, on the assumption that their prices follow an identifiable recurrent pattern — backed by a strong relationship between the companies. Essentially, RD and SC are opposite sides of the same coin; they both derive their revenues from a fixed partition of the income generated by the entire corporate group. Indeed, they are linked by corporate charters stipulating that 60% of the income received by the group will be allocated to RD, while the 40% remaining will be allocated to SC. Therefore, it is possible to extract an exact relationship between the two stocks’ prices (see sidebar “Pairs relationships”).

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