Timing The Market With Pairs Logic by Perry Kaufman
Release The Stress!
Fundamentally different strategies, drawing from a broad set of markets, will offer better risk protection during times of market stress than any one strategy, regardless of the mar-kets selected for the portfolio. In this article, you will get an overview of a timing method that you can implement in your trading, followed by the mechanics of that system.
Arbitrage is one of the great financial strategies, and pair trading, which is relative value arbitrage, ranks high on the list of all-time successes. The premise is that two related stocks will only diverge for a short time, so that buying the weaker and selling the stronger is a high-probability trade. In my 2010 book Alpha Trading, I introduced the stress indicator as a method for timing the entries & exits into pairs trades (see Figure 1).
But there are practical problems with traditional pair trading:
•It can be difficult to sell short one leg of the pair.
•A high correlation between two stocks or a stock and an index assures success but will cause profits to be small.
•The net profit can also be small because of competition with commercial traders, since it’s a popular method.
•Retirement accounts don’t allow short sales.