PairsTrading

Simple ideas are usually very powerful. “Pairs trading” is based on one such simple but powerful idea which generated millions in profits for various firms. Morgan Stanley which first implemented this strategy and a host of other firms which copied this technique and made a lot of money.

Pairs trading is based on 2 constructs :

First, Any stock moves in a random way , however there is a systematic component to it and idiosyncratic component. In simple terms  , there is a component you can identify with a set of factors , and there is another component which is stock specific. So, you can pick a pair of stocks such that the systematic component of one stock is related to the systematic component of another stock.. Thus you have a grip on the spread.

Second, test for the mean reversion of the idiosyncratic risk. Meaning, see whether the error component of the pair exhibits a mean reversion.

Once both the things are known for a pair or you can find a pair which satisfies the above 2 constructs,, all one needs to do is to take a long-short position , dynamically hedge the position and make money whenever there is a mean reversion, meaning whenever the spread hits 0. In a stock universe of lets say 5000 stocks, one needs to compare 2 million pairs…Though the technique is simple, if you want to test on the universe  , it is going to time intensive…This book talks about a technique to get over this problem.

The book is very well written because it tries to explain a lot many of things intuitively, with proper reasoning for all the equations used in the book.

This technique was first implemented in 1987 and traders have ripped apart the strategy in US in the last 20 years. So , What does one learn from reading up this dead strategy ? May be some knowledge about what worked and why it worked in a specific market.

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